Paying Taxes on Scholarships

  They say no good deed goes unpunished and students who do very well and earn lots of scholarships might have to take this adage to heart. That’s because the scholarships those students earn could be taxed by the IRS as income.

            There are some caveats to this though and it’s important to note that not all of the scholarships a student receives will be taxed. The IRS does not tax scholarships for degree-seeking students as long as the money is used for tuition and/or required fees, books, supplies, and equipment. Further, it’s worth pointing out that this definition is different and a little bit more restrictive than what we consider “qualified educational expenses” when we are discussing 529 plans. 529 funds can be used for things like housing, meals, and transportation. Those would all fall outside of the scope of tax-free expenses when it comes to scholarships and taxes.

            So, really, you could argue that paying taxes on scholarships is a good problem to have. It is only going to happen if a student earns more scholarship money than their tuition and other required expenses. So, let’s imagine a student is attending a school and is facing a $8,000 tuition bill for the semester. Let’s also imagine they received a total of $10,000 in scholarships. The first $8,000 of those scholarships will be tax free as they wipe out the tuition. The remaining $2000 will count as income for the student and will be taxed. However, what is leftover after the taxes can be used by the student for housing expenses, or perhaps anything they want. The difference in the $2000 and taxes paid on it is going to be more money than the student would have had if they hadn’t earned all those scholarships in the first place. As a friend once told me, “anytime you pay income taxes, you made money.”

            Most scholarship money is going to flow through a student’s college or university. If they earn a state scholarship, maybe one from the school, and perhaps others from somewhere else, all of that will end up going through the financial aid office. The people there should do all the math for you, pay your tuition, and calculate any excess scholarships you’ll need to pay taxes on. When a student earns more money than they owe a college, the college will typically issue the student a check for the difference and 1098-T that is used to report the excess scholarships to the IRS. In instances where the student earns a scholarship that doesn’t flow through a university, as is the case with many “local scholarships” that might originate from an area civic club, foundation, group, etc., the money won’t be reflected in the 1098-T they receive from the school. In those cases, students would likely be responsible for self-reporting those scholarships to the IRS.