- Scholarships can give your child an opportunity to attend a school previously thought to be out of reach. However, the potential tax implications that come with scholarships are often overlooked.
- Be on the lookout for the two tax forms associated with your student’s education: the 1098-T (from the school) and the 1099-Q (from your 529 savings plan provider.)
- The IRS leaves it up to you, the taxpayer, to calculate if and how much of your scholarship is taxable.
For many families, a college scholarship can ensure your child will attend college. For others, a scholarship can allow your student to attend his or her dream school. Wherever your child chooses to attend college, a scholarship can reduce or eliminate a student’s or parent’s debt burden.
However, a scholarship is NOT always free money. Many students and their families are surprised to learn scholarships come with certain tax obligations and may trigger tax consequences. There are two tax questions your CPA (or tax software) will likely ask:
- Is any of the scholarship income considered taxable?
- Was any portion of the withdrawal from the student’s 529 plan or other college savings account used for non-qualified expenses?
The considerations below can help you answer those questions:
Understanding Tuition-related Documents You Receive When Filing Your Taxes
a. From the University (1098 – T)
Between January and March, you will receive Tax Form 1098-T from your student’s college. The 1098-T details how much you paid for qualified education expenses (see box 1).
The IRS does NOT consider room & board, insurance, medical expenses, transportation, or personal living expenses to be qualified education expenses. Those expenses are not counted towards the box 1 total.
IMPORTANT: What the 1098-T considers a qualified expense is not the same as what your 529 plan considers to be a qualified expense. It is always best to discuss if an expense will be considered a qualified expense with your 529 provider. For more information on this subject, see our article on 529 College Savings Plan Rules and Reminders.
You will also want to review the amount listed in box 5 to determine whether your student’s scholarship will be considered taxable. This box reports the scholarship amount your child received.
b. From Your 529 Provider (1099-Q)
Form 1099-Q shows the total distribution from your child’s 529 account during the previous tax year. The form DOES NOT show how the distributions were spent. It is imperative you keep receipts and supporting documents that reconcile the 1099-Q amounts with the total spent on qualified expenses. Maintain these records for 7 years and keep a backup copy in case of an audit.
Typically, box 1 of Form 1099-Q lists the total distributions taken, box 2 includes the earnings portion of the distributions, and box 3 includes the cost basis, which shows how much of the distribution was money you contributed (i.e., the principal, not the earnings).
The earnings or growth of your 529 plan would be any dollar amount above what you contributed to the account (principal amount).
The earnings portion of a non-qualified 529 plan distribution is subject to income tax and a 10% penalty.
For more information see “Reporting 529 Plan Withdrawals on Your Federal Tax Return.”
How and Where Are Scholarships Reflected in Your Taxes?
It’s hard to believe, but the IRS leaves it up to you, the taxpayer, to calculate if and how much of your scholarship is taxable. To get started, let’s identify which portion of your student’s scholarship, if any, is taxable.
According to the IRS, all three of the conditions below must be met for a scholarship or fellowship to be considered tax-free:
- Your student must be a degree candidate at an eligible educational institution. View the full list of eligible institutions here.
- The scholarship or fellowship money must be used for qualified education expenses. This includes tuition and fees, books, and course- or degree-related costs (i.e., supplies for certain classes). It does NOT include additional costs such as room, board, and travel.
- The money received cannot be in the form of wages for teaching or other work that your student performs.
For a scholarship to be completely tax-free, ALL the money must be used for qualified expenses. For example, if your student received a $20,000 scholarship and tuition at his or her school is $25,000, no taxes are owed on that money. However, if your student received a $25,000 scholarship and $5,000 of that was spent on room and board, the $5,000 is considered taxable income.
When Is a Scholarship Considered Taxable Income?
When looking at your 1098-T, you want to review box 1 carefully. Are the qualified expenses in box 1 greater than the amount shown in box 5 (scholarships or grants)? If box 1 is greater than box 5, then it is a tax-free scholarship. However, if box 5 is larger than box 1, then the portion above the amount shown in box 1 is considered taxable income. This taxable amount will flow through to your 1040 via Schedule 1, line 8 (“Other Income”). You will write “SCH” for the “type code,” followed by the taxable amount in this section.
For more information, see “Paying for College: Are Scholarships Taxable?”
Occasionally, schools list only their tuition and fee amounts in box 1. You will want to confirm your school’s policy with them. If you need to modify this number, you can include your actual spending on required textbooks, supplies, tuition, and equipment. Keep your relevant receipts and base your calculation of the taxable portion on the actual qualified tuition and related expenses paid. This may reduce the taxable portion of your scholarships.
Another situation that results in a taxable scholarship is when a graduate student has a fellowship or scholarship that requires them to be a teaching assistant. Scholarship and fellowship money in the form of compensation is taxable, regardless of how the money is spent.
If the school sends your student a W-2 tax form, that’s another indicator that this money is taxable. The school considers this money income - NOT a tax-free scholarship. In this case, the only amount you input on your taxes is for your child’s W-2 income.
Understanding the Hidden Costs
In my next post, we will take a closer look at the tax implications of 529 plans and other tax credits. If you or someone close to you has concerns about hidden costs or tax implications of your child’s scholarship, please reach out. We’re happy to help.
Taylor Vance, CFP® is an Advisor at Soundmark Wealth Management, LLC. Taylor works closely with individuals and families to help them define their financial goals and implement an ongoing financial planning process.