January 19, 2022
Good news: You just found out that your high school senior son or daughter will be receiving a sizeable scholarship at a prestigious university next fall. But what are the tax consequences?
In most cases, scholarships awarded to students are exempt from federal income tax, assuming certain conditions are met. Comparable rules apply to fellowships for doctorate programs. However, there are some situations where a scholarship or fellowship results in taxable income that students must report on their federal income tax returns.
Generally, your child won’t have to pay any tax on a scholarship that goes toward obtaining a college education. It doesn’t matter if the money is coming from the school itself or another source.
To qualify for the tax exemption, the following three requirements must be met:
- The child is a degree candidate at an eligible educational institution. This is an institution with a regular faculty and curriculum and a regularly enrolled body of students.
- The scholarship is used to pay for qualified expenses. This includes tuition and fees, books and related costs like supplies or equipment required for specific classes. However, it doesn’t cover room and board, travel and research costs.
- The award doesn’t represent wages for teaching, research or other work.
In some cases, only a portion of the scholarship is exempt from tax. For instance, suppose your child receives a $25,000 award, where $15,000 goes to tuition and $10,000 to room and board. In this case, only $15,000 is excluded from tax. The remaining $10,000 is treated as taxable income.
For these purposes, a “degree candidate” is defined as someone who:
- Attends a primary or secondary school or is pursuing a degree at a college or university, or
- Attends an educational institution that 1) provides a program that’s acceptable for full credit toward a bachelor’s or higher degree, or offers a program of training to prepare students for gainful employment in a recognized occupation, and 2) is authorized under federal or state law to provide such a program and is accredited by a nationally recognized accreditation agency.
Scholarships are fully taxable to the student who isn’t a degree candidate at an eligible institution. A scholarship or fellowship is also taxable if it represents compensation.
For example, suppose your child in graduate school is required to serve as a teaching assistant to qualify for a $20,000 award. In this situation, the entire amount is taxable, even if part or all of the money goes to tuition. The university will generally provide Form W-2 to the student, stating the income amount that must be reported on their federal income tax return.
What about athletic and music-performance scholarships? The rules in this area are continuing to evolve, but currently these amounts are generally exempt from tax, even if the school reasonably expects the student to participate in a particular activity. Generally, the scholarship must continue even if the recipient is injured or simply chooses not to participate.
There are, however, a few exceptions to the general rules requiring taxation of scholarships and fellowships when the student renders services in exchange.
Notably, the IRS has said that payments made through the GI Bill aren’t considered to be scholarships, so they don’t constitute taxable income. Moreover, if your child participates in the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program, the payments are generally exempt from tax if the amounts are used to pay qualified expenses.
There’s also an exception for qualified tuition reductions received by employees of an educational organization. Graduate students who receive tuition reductions or waivers in exchange for teaching or research activities need not report these benefits as income. Similarly, tuition reductions enjoyed by an educational organization’s employees or their family members are tax-free, provided the program doesn’t discriminate in favor of highly compensated employees.
Keep in mind that student loans clearly aren’t scholarships. Therefore, loans are subject to a different set of rules.
Kiddie Tax Complications
The kiddie tax may throw an extra wrinkle in the rules for taxing scholarships. Be careful to avoid adverse tax consequences.
Briefly stated, the kiddie tax applies to “unearned income” above an annual threshold that’s received by a dependent child under age 19 or a full-time student under age 24. The annual income threshold for 2022 is $2,300, up from $2,200 in 2021.
If the kiddie tax comes into play, the excess is taxed at the top tax rate of the child’s parents — not the child’s tax rate — regardless of the source of the income. Currently, the top federal tax rate on ordinary income is 37%.
Clearly, if income is received by a student for a fellowship where their services are compensated and are reported on Form W-2, the grant constitutes taxable “earned income” and doesn’t cause any kiddie tax problems. However, if a scholarship is used for purposes other than for qualified expenses, the amount is generally considered to be unearned income. This may occur, for example, if your child is awarded a scholarship for room and board.
Don’t forget to factor this into your tax calculations for the year. Also, be aware that taxable scholarships may actually increase a higher education credit.
The federal tax rules for scholarship awards can be confusing. Before you start counting on your student’s apparent good fortune, you may want to meet with your professional tax advisor to determine the tax ramifications for your family.