When it comes to financial aid for higher education, even "free" sources of money could leave you owing the IRS.
Scholarships, fellowship grants and teaching assistantships are instrumental in helping families pay for college.
Consider that the average tuition and fees for full-time students attending a private four-year college during the 2017-2018 school year is $34,740, according to the College Board. Meanwhile, the average in-state tuition and fees for public four-year colleges is $9,970.
But those free sources of financial aid may come with an unexpected price tag in the form of income tax.
Generally, a scholarship that covers tuition and fees is tax-free. Money that covers room and board is not.
The difference isn't always clear, however, particularly if stipends and teaching assistantships are involved.
"The problem you run into is when the school says, 'We're giving you $10,000 and calling it a scholarship,'" said Tim Steffen, director of advanced planning at Robert W. Baird & Co. in Milwaukee. "Just because the school says it's tax-free, doesn't mean it is."
Here's when you should be on the lookout for taxes connected to financial aid.
IRS guidance
Students must meet two conditions in order for their scholarship or fellowship to be considered tax free, according to the IRS:
- You must be a candidate at an educational institution with a regular faculty and curriculum. This school must have a regularly enrolled body of students in attendance.
- The money you receive is for tuition and fees required for enrollment or fees, books, supplies and equipment needed for courses.
Here's what's taxable: Money that goes toward incidental expenses, including room, board and travel.
You also owe taxes on any cash you get as payment for teaching, research and other services as a condition of receiving the money in the first place.
Finally, you may also owe taxes on the portion of a scholarship that exceeds the total tuition, fees, books, supplies and equipment — even if the funds are earmarked for these expenses, said Mark Kantrowitz, student loan expert and publisher at the website Private Student Loans Guru.
Students who receive money for services that are required by the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program do not need to pay taxes on the amounts they get.
Additional complexity
Fellowships and research assistantships are a little more complicated. These programs may combine a tax-free tuition waiver and a taxable living stipend.
The stated purpose of the funds and how you use the money will matter.
"Let's say that you get a partial tuition waiver and a living stipend, and you use the stipend to pay the tuition," said Kantrowitz.
"It will still be treated as taxable because it was designated for living expenses, as opposed to tuition," he said.
Tax reporting
If a school offers a student money that's considered taxable income — perhaps as part of a teaching assistantship or fellowship — then it must provide the student with a Form W-2, reporting taxes withheld.
Prior to tax time, your school will also report qualified tuition expenses on Form 1098-T, along with the details on the amount of scholarships, fellowships and grants received.
Hold onto your receipts for textbooks, supplies and equipment, said Kantrowitz. Form 1098-T won't have that information.
Who's ultimately responsible for reporting the tax load? For dependent students, Mom and Dad would report the scholarships on their return.
In this case, a taxable scholarship is considered "unearned income," subjecting it to the kiddie tax if the child is under 19 or is a full-time student under age 24, Steffen said.
Under the old tax code, this would've meant that unearned income exceeding $2,100 is subject to the parents' rates, and families would use Form 8615 to calculate the liability.
Under the new tax law, however, the "unearned income" will instead be subject to the trust income tax rates — meaning that taxable income exceeding $12,500 will be taxed at the top rate of 37 percent.
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"For children of parents at lower levels of income, this change in the kiddie tax could mean a big tax increase," Steffen said.
"On the other hand, kids of higher-income parents may get a small break by getting to start over at the bottom of the trust tax brackets," he said.
A graduate student who files on his own would report the scholarship or fellowship on his own income tax return.
Graduate students should also bear in mind that as recently as last fall, Congress had set its sights on taxing tuition waivers as part of an overhaul of the tax code.
Tuition waivers can be significant, particularly when they cover a whole year's worth of schooling. "It can be in the $40,000 to $50,000 a year range," said Kantrowitz. "It's a substantial tax bill that would exceed the living stipend."
This provision ultimately didn't make it into the Tax Cuts and Jobs Act.
"It shows where Congress is leaning on these things," said Steffen. "It could come up again."
Ask your school
The tax treatment of "free money" should be one more factor to consider when selecting a college. Here's what you should ask your financial aid officer.
- To what extent is this fellowship or scholarship a payment for service? If your school gives you $10,000 for you to conduct research at school, ask for a breakdown of the funds, said Steffen. How much of this money is a payment for service as a research analyst? That amount may be taxable. How much is an actual scholarship? This amount is likely tax-free.
- What tax documents should I look out for? If any of your "free money" is considered pay, you should get a Form W-2 so that you can file your income tax return.
- What's the actual cost after aid and taxes? Compare your offers across schools by calculating the net price — that is, what's the total cost of attendance after accounting for total aid received? Make sure to weigh the tax impact of scholarships and fellowships, too, said Kantrowitz.
