Here's something to remember amid college financial aid season: The IRS might want its piece of your scholarship.
Sources of "free money," including scholarships, assistantships and grants, are instrumental in helping families afford the growing cost of college.
The average annual price tag for in-state students at a four-year state school is $21,370, according to the College Board. That includes tuition, fees, room and board.
The cost was $48,510 for private institutions, the College Board found.
While you generally don't have to repay scholarships and assistantships, the catch for families is that they may be subject to income tax.
"Any amount of the scholarship that's used to pay for tuition, fees, books, supplies and any other equipment that's required for the student's courses is tax-free," said Tracie Miller-Nobles, CPA and member of the American Institute of CPAs' consumer financial education advocates.
"Where students get into trouble is when the scholarship becomes taxable," she said. "If you use it to cover your dorm room or your meal plan, that might be taxable."
Scholarships and fellowships must meet two conditions to be tax-free, according to the IRS.
You must be a candidate for a degree at an educational institution that maintains a regular faculty and curriculum. The school must have a regularly enrolled body of students in attendance.
The money you get must be used for tuition and fees required for enrollment or attendance at an educational institution. You can also use this money for books, supplies and equipment required in your courses.
Money that covers incidental expenses, including room, board, travel and optional equipment, is taxable.
You are also on the hook for taxes on any money received as payment for teaching, research and other services as a condition of receiving the cash.
You might 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 those costs, said Mark Kantrowitz, student loan expert and vice president of research at Savingforcollege.com.
Students who get money for services required by the National Health Services Corps Scholarship Program or the Armed Forces Health Professions Scholarship Program don't need to pay taxes on the amounts received.
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.
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, Kantrowitz said. Form 1098-T won't have that information.
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