Don’t Let Scholarship Money Create an Unexpected Tax Bill

Receiving a college scholarship is an exciting accomplishment and, in some cases, allow a student to attend a school they may not have been able to afford. However, many parents are often unaware that not all scholarship money is tax-free.

The good news is that, with proper planning, many families can minimize or avoid unexpected tax consequences associated with scholarship funds. The key is understanding which expenses qualify as tax-free under IRS rules and which do not.

When Is Scholarship Money Tax-Free?

In general, scholarship or grant money is not taxable if the scholarship is used for qualified education expenses.

Qualified Expenses (Generally Tax-Free)

Scholarship funds used for the following expenses are generally tax-free:

• Tuition
• Mandatory enrollment fees
• Required textbooks
• Required course materials
• Required supplies
• Equipment that is specifically required for enrollment or attendance (such as a required laptop if mandated by the school or course)

Expenses That Can Make Scholarships Taxable

Scholarship money used for non-qualified expenses is generally considered taxable income to the student, even if the scholarship itself was awarded tax-free.

Examples include:

• Room and board
• Dormitory fees or off-campus rent
• Meal plans and personal living expenses
• Transportation, parking and travel expenses
• Health insurance
• Optional computers or electronics that are not required by the school
• Entertainment or recreational costs

For many students, this taxable income may still result in little or no federal income tax because of their relatively low income. However, it is important to understand that these amounts may still need to be reported on the student’s tax return.

Keep Good Records

Parents should maintain documentation showing how scholarship funds were spent, including:

• Tuition statements (Form 1098-T)
• Receipts for books and required supplies
• Course syllabi showing required materials
• Billing statements from the college
• Scholarship award letters

Good documentation can be invaluable if questions arise later.

Coordinate Scholarships With Education Tax Credits

Many families overlook an important planning opportunity.

The American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC) cannot be claimed for expenses that were already paid with tax-free scholarship funds.

In some situations, it makes sense to treat a portion of a scholarship as taxable so that parents can claim a larger education tax credit, potentially resulting in a lower overall family tax bill, depending on their circumstances

Because these rules can be complex, coordinating scholarships with education tax credits is often worth discussing with a CPA or financial advisor.

What About 529 Plans?

If your child receives a scholarship, you generally have several options regarding your 529 account:

• Leave the funds invested for graduate school or another beneficiary.
• Change the beneficiary to another qualifying family member.
• Withdraw an amount equal to the scholarship without paying the normal 10% penalty on earnings (although the earnings portion of the withdrawal may still be subject to income tax).

This flexibility may help families avoid unnecessary penalties while making the most of their education savings.

Does It Matter Whether the Money Comes from Financial Aid or a Merit Scholarship?

Many parents assume these rules apply only to academic or athletic scholarships, but the tax treatment is generally the same for most forms of educational assistance.

Whether your child receives a merit scholarship for academic achievement, an athletic scholarship, a need-based grant such as a Pell Grant, or institutional financial aid from the college, the determining factor is typically how the funds are used—not why they were awarded.

Final Thoughts

A scholarship is a tremendous financial benefit, but understanding the tax rules can help your family keep even more of that money.

By using scholarship funds first for qualified education expenses, maintaining good records, and coordinating your education tax strategy, you may be able to minimize taxes and maximize the value of your child’s college funding.

Every family’s situation is unique. If your child has received a significant scholarship, consulting with a qualified tax professional or financial advisor can help ensure you’re making the most tax-efficient decisions.

Disclosures:

This article is intended for general educational purposes only. Tax laws and IRS guidance are subject to change and vary based on individual circumstances. Readers should consult their tax advisor regarding their specific situation before making tax or financial decisions.

Opal Advisors, LLC is an SEC-registered investment adviser. Registration does not imply a certain level of skill or training. This material is provided for informational purposes only and should not be construed as investment, tax, or legal advice. Investing involves risk, including the possible loss of principal.