For parents faced with the soaring cost of higher education, a scholarship can provide welcome financial relief. Most parents assume that scholarships are tax-free, but that’s not always the case.

Scholarships 101

Scholarships received by degree candidates are tax-free to the extent they’re used to pay for qualified tuition and related expenses. These expenses include:

• Tuition and fees required to attend the school, and
• Fees, books, supplies and equipment required for courses at the school.

This tax break isn’t available for other school-related expenses, such as room and board, travel, and research. Also, with certain exceptions, scholarships aren’t tax-free to the extent that they represent payment for teaching, research or other services required as a condition for receiving the award.

Suppose, for example, that your child receives a full-ride scholarship totaling $70,000 per year. It covers $55,000 in qualified tuition and related expenses, plus $15,000 for room and board. Assume that the child isn’t required to perform any services in exchange for the scholarship. The $55,000 used for qualified tuition and expenses is tax-free, but the $15,000 used for room and board is taxable.

Exceptions to the payment-for-services rule

Certain scholarships are tax-free even though they’re tied to the performance of services. Examples include awards received under:

• The National Health Service Corps Scholarship Program,
• The Armed Forces Health Professions Scholarship and Financial Assistance Program, or
• A comprehensive student work-learning-service program operated by one of a handful of federally recognized “work colleges.”

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.

What about scholarships tied to the recipient’s participation in certain activities, such as athletic or music performance scholarships? Generally, these scholarships are tax-free, provided the student is expected, but not required, to participate in a particular sport or music ensemble. In other words, to avoid taxation, the scholarship must continue even if the recipient is injured or simply chooses not to participate.

Reporting and kiddie tax rules

If a scholarship is partially taxable, the student should report this income on Form 1040. Income that constitutes payment for services is considered earned income and will be included on the student’s Form W-2. Form 1098-T, prepared by the educational organization, will show scholarships received and amounts paid for qualified tuition and related expenses. Review this information carefully, however, because some qualified expenses, such as books and equipment, may not be included.

A scholarship is taxable to the extent that money that’s not payment-for-services exceeds qualified tuition and related expenses. For example, scholarship funds used for room and board are taxable.

The taxable amount is also considered unearned income for purposes of the “kiddie tax.” So, depending on the recipient’s other income sources, a portion of this income may be taxed at the parents’ marginal rate. Your tax advisor can help determine whether the kiddie tax applies to your child.

No surprises

Scholarships can do wonders to offset the high cost of a college education. To avoid tax surprises, however, be sure to familiarize yourself with the tax treatment of these awards.

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