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Scholarships are Tax-Free Except for:

Scholarships are generally tax-free, whether for elementary or high school students, for college or graduate students, or for students at accredited vocational schools. It makes no difference whether the scholarship takes the form of a direct payment to the individual or a tuition reduction.

For the scholarship to be tax-free, certain conditions must be satisfied. The most important are that the award must be used for tuition and related expenses (and not for room and board) and that it must not be compensation for services.

A scholarship is tax-free only to the extent it is used to pay for (1) tuition and fees required to attend the school or (2) fees, books, supplies, and equipment required of all students in a particular course. For example, if a computer is recommended but not required, buying one wouldn’t qualify. Other expenses that don’t qualify include the cost of room and board, travel, research, and clerical help.

To the extent a scholarship award isn’t used for qualifying items, it is taxable. The recipient is responsible for establishing how much of the award was used for qualified tuition and related expenses so as to be tax-free. You should maintain records (e.g., copies of bills, receipts, cancelled checks) that reflect the use of the scholarship money.

 A scholarship isn’t tax-free if the payments are linked to services that your child performs as a condition for receiving the award, even if those services are required of all degree candidates. Thus, a stipend your child receives for required teaching, research, or other services is taxable, even if the child uses the money for tuition or related expenses.

Any portion of the award that is taxable as payment for services is treated as wages.  Your child should receive a Form W-2 showing the amount of these “wages” and the amount of tax withheld, but any portion of the award that is taxable must be reported, even if no Form W-2 is received.

The dependency exemption that you claim for your child shouldn’t be threatened by the scholarship. To claim an individual as your dependent, you must meet a support test. Although education is a support item, a special rule provides that educational costs covered by a scholarship for a dependent who is a child of the taxpayer aren’t included in the calculation of total support.

The tax-free scholarship may limit other higher education tax benefits to which you or your child may be entitled. Neither you nor your child may claim a credit, deduction, or exclusion for expenses paid with tax-free scholarship funds.

Thus, if your child receives a tax-free scholarship and his or her higher education expenses also qualify for any of the following credits, deductions, and exclusions, the expenses taken into account in computing any of these other benefits must first be reduced by the tax-free amounts used to pay the expenses.

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