Are Scholarships Tax Deductible? Understanding the Tax Implications of Scholarship Funds
Scholarships are a hugely impactful way to support the next generation, helping students cover the cost of tuition and other school fees. Scholarships can help make the cost of education a little less burdensome for students and families. But are scholarships taxable? The answer, unfortunately, isn't always straightforward. It's important to prepare yourself with the facts of your scholarship requirements and the applicable tax law. To gain a better understanding of how to handle your scholarship on your taxes, it’s important to consider some definitions and applicable tax laws.
Scholarship Basics
According to the Internal Revenue Service (IRS), “A scholarship is generally an amount paid or allowed to a student at an educational institution for the purpose of study". A fellowship grant is generally an amount paid or allowed to an individual for the purpose of study or research. Scholarships are financial awards often given to students who meet certain need-based criteria or merit-based achievements based on their academic, athletic or extracurricular performance, or on other areas of interest like field of study, hobbies and more. The student may be either an undergraduate or a graduate.
When are Scholarships Taxable?
Typically, scholarships that pay for qualified educational costs at eligible educational institutions aren’t considered taxable income. The same applies to grants received to pay for specific schooling costs. In short, whether scholarships are taxable depends on how much you receive and how you spend the funds. The IRS has specific conditions for a scholarship not to be taxed. The good news is that typically the IRS does not see scholarships as income (which means it's not taxable).
To avoid a scholarship being subject to taxation, you’ll need to spend the funds on qualified educational expenses. Generally, this means tuition and fees required to enroll or attend the eligible educational institution. Course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. This is true even if the fee must be paid to the institution as a condition of enrollment or attendance. The key to having a tax-free scholarship is that the expenses the scholarship covers must be a requirement for all students in your program. They can't be things that go beyond what you need to satisfy your program requirements. The key requirement for having scholarships cover these course-related expenses tax-free, is that they must be required of all students in your course.
When are Scholarships Taxable?
Some scholarship funds are subject to taxation. If you have scholarship money left over after covering your qualified education expenses, you'll need to include that amount as part of your gross taxable income. If you have money left over after covering your qualified education expenses and use it on other costs, these funds generally count as taxable income.
Read also: Camp Scholarships Guide
It’s important to note that even if the scholarship covers costs such as accommodation or food (expenses that are not directly related to tuition but are still essential for a student), there may be tax implications. If you have scholarship money left over after covering qualified educational expenses, you may need to include the remainder as part of your gross taxable income.
In some cases, a scholarship is really more of a stipend, providing compensation for services while you’re in school or for services you’ll provide in the future. If you receive a scholarship with the condition that you provide services in the future, you’ll typically need to count the scholarship as income in the year you receive it. Amounts received as payments for teaching, research, or other services required as a condition for receiving the scholarship or fellowship grant.
If you receive scholarship funds that exceed your qualifying educational expenses, the amount above these necessary costs is subject to taxation. Likewise, if you receive a scholarship that you use to pay for room and board, books or supplies that aren't required, these funds are generally subject to taxation.
Grants vs. Scholarships
Grants are a form of financial aid that don’t require repayment. Generally, grants are awarded based solely on financial need. Unlike scholarships, grants might link to specific projects or research. Depending on how the student uses scholarship funds, they are typically not considered taxable income.
Tax Credits: American Opportunity Credit and Lifetime Learning Credit
Tax credits such as the American Opportunity Credit and the Lifetime Learning Credit can be used to reduce the cost of pursuing post-secondary education. Scholarships and grants aren’t the only ways to get financial assistance to pay for higher education.
Read also: Benefits of NSHSS Scholarships
The American Opportunity Credit allows students or their parents an opportunity to reduce the cost of attending college through claiming qualifying education expenses as a tax credit on their federal income taxes. To claim this education tax credit, the student must be at least a half-time student who hasn’t completed the first four years of college and is working toward a degree. In addition to required tuition and fees, the credit applies to other expenses like books, supplies and equipment, but not room, board, transportation expenses or medical insurance. The credit is equal to 100% of the first $2,000 of qualifying expenses plus 25% of the expenses in excess of $2,000.
Whether you’re pursuing a college degree, higher education coursework independent of a degree or other educational activities to develop your career, another tax credit to consider is the Lifetime Learning Credit. Like the American Opportunity Credit, this credit also reduces your tax bill on a dollar-for-dollar basis for a portion of the tuition, fees and other qualifying expenses you pay for yourself, your spouse or a dependent to enroll in qualifying coursework. Another distinction is that you can’t double dip with these two educational credits. That means you can’t claim both the Lifetime Learning Credit and the American Opportunity Credit in the same year for the same student.
To claim the AOTC or LLC, use Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits). You can't claim the AOTC if you were a nonresident alien for any part of the tax year unless you elect to be treated as a resident alien for federal tax purposes.
Optimizing Scholarships and Tax Credits
The IRS has provided some helpful guidance on how to maximize your scholarships and tax credits, delivering you the most savings possible for your situation. One tax optimization strategy works by considering some of your scholarship money as taxable income by using it for living expenses rather than applying it toward your tuition expenses. This can allow for some of your tuition expenses to be eligible for an education credit that otherwise would have been paid by the tax-free scholarship money. In some cases, you might be better off excluding all of the scholarship from your taxable income by applying it only toward tuition expenses.
For example, if you have a grant or scholarship that fully covers all of your tuition, fees, and books, then you can't claim the American Opportunity Credit because you didn't actually pay for qualifying expenses. If, instead, you claim some of the grant or scholarship as income and don’t use it for your eligible expenses, this then leaves you with some qualified expenses to pay and gives you the ability to claim the tax credit. Since up to $1,000 of the American Opportunity Credit is refundable, you can take part of a scholarship and choose to make it taxable income.
Read also: Scholarship Guide
Student Loan Interest Deduction
Another useful tax deduction you may be able to claim comes from the student loan interest deduction. For 2024, you can deduct the student loan interest paid if your modified adjusted gross income (MAGI) is below $95,000 when filing as Single or $195,000 if you file as Married Filing Jointly. Student loan interest is interest you paid during the year on a qualified student loan. For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return before subtracting any deduction for student loan interest. The student loan interest deduction is taken as an adjustment to income.
Generally, personal interest you pay, other than certain mortgage interest, is not deductible on your tax return. However, if your modified adjusted gross income (MAGI) is less than $80,000 ($160,000 if filing a joint return), there is a special deduction allowed for paying interest on a student loan (also known as an education loan) used for higher education.
Reporting Scholarships
Federal Treasury Regulations require colleges and universities to annually report scholarship awards received by students to the Internal Revenue Service (IRS) using the IRS Tax Form 1098-T (Tuition Statement) for the purposes of determining a student's eligibility for the Hope and Lifetime Learning education tax credits. Scholarship Awards Reported to the Federal Government using the IRS Tax Form 1098-T.
If filing Form 1040 or Form 1040-SR, include the taxable portion in the total amount reported on Line 1a of your tax return. If any part of your scholarship or fellowship grant is taxable, you may have to make estimated tax payments on the additional income. If filing Form 1040 or Form 1040-SR, include the taxable portion in the total amount reported on the “Wages, salaries, tips” line of your tax return.
Work-Related Education Expenses
If you are an employee and can itemize your deductions, you may be able to claim a deduction for the expenses you pay for your work-related education. Your deduction will be the amount by which your qualifying work-related education expenses plus other job and certain miscellaneous expenses is greater than 2% of your adjusted gross income. If you are self-employed, you deduct your expenses for qualifying work-related education directly from your self-employment income.
You can deduct the costs of qualifying work-related education as business expenses. The education is required by your employer or the law to keep your present salary, status or job. Education you need to meet the minimum educational requirements for your present trade or business is not qualifying work-related education. The education is required by your employer or the law to keep your present salary, status or job.
Qualified Tuition Programs (QTP)
States may establish and maintain programs that allow you to either prepay or contribute to an account for paying a student's qualified education expenses at a postsecondary institution. Eligible educational institutions may establish and maintain programs that allow you to prepay a student's qualified education expenses. If you prepay tuition, the student (designated beneficiary) will be entitled to a waiver or a payment of qualified education expenses.
You can't deduct either payments or contributions to a QTP. No tax is due on a distribution from a QTP unless the amount distributed is greater than the beneficiary's adjusted qualified education expenses. Qualified expenses include required tuition and fees, books, supplies and equipment including computer or peripheral equipment, computer software and internet access and related services if used primarily by the student enrolled at an eligible education institution.
Coverdell Education Savings Account (ESA)
A Coverdell ESA can be used to pay either qualified higher education expenses or qualified elementary and secondary education expenses. Income limits apply to contributors, and the total contributions for the beneficiary of this account can't be more than $2,000 in any year, no matter how many accounts have been established. Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed.
There is no tax on distributions if they are for enrollment or attendance at an eligible educational institution. This includes any public, private or religious school that provides elementary or secondary education as determined under state law. If the distribution exceeds qualified education expenses, a portion will be taxable to the beneficiary and will usually be subject to an additional 10% tax.
Creating a Scholarship Fund
Scholarships are a hugely impactful way to support the next generation. Creating them on your own can be tricky, but there are easy solutions available. Scholarship funds are financial awards that help students pay for eligible educational expenses, ranging from tuition to student loans to textbooks and more.
The IRS has strict guidelines that specify how to ensure that scholarships are awarded based on merit (and not as a lottery) and clearly defines the permitted expenses for which scholarship funds can be used. If you start a scholarship fund on your own, you'll need very careful planning. You’ll need to clearly define eligibility criteria, outline how applications must be submitted and how they must be evaluated, and establish a fair selection process for winners. You'll also need to work with a sponsor 501(c)(3) non-profit if you'd like the donation to be tax deductible and to avoid creating an income tax burden for your scholarship winners.
The first step is to decide how much you'd like to donate, how much you're willing to spend in fees, and how much you're expecting to fundraise with your friends, your family, and your community.
Here are the common options for creating a scholarship, along with how much they typically cost:
- Endowing a Scholarship at a Specific University: Donation Minimum: $50k-$100k, depending on the school's requirements. Fees: Administrative / setup fees up to 5%. Supports fundraising: No
- Creating Your Own Non-Profit: Donation Minimum: Typically $1k+ to fund the new entity. Fees: Typically, $5k-10k in legal fees to set up a new entity and achieve non-profit status.
Lastly, don't underestimate the time investment that could be required. Now it’s time to shape your scholarship and make it clear who it’s for.
The next step is to define the important details that will guide applicants and ensure the scholarship is awarded to the right person. Here’s what you need to do:
- Define scholarship eligibility criteria (e.g., field of study, financial need, community involvement).
- Specify selection criteria (e.g., grades, personal story, extracurriculars)
- Write a thoughtful scholarship description explaining its purpose and who it aims to help.
- Create a clear and engaging application prompt.
These details will help applicants know what’s expected and give you a solid framework for selecting the most deserving candidate.
The next step is to establish how you’ll collect applications, handle different submission types, and ensure your donations are tax-deductible. Here's what you'll need for a successful setup:
- Create a clear, easy-to-follow process for applicants.
- Make sure you can accept different submission formats (e.g., essays, images, videos, or other creatives).
- Spreading the word is key to attracting the right applicants.
The next step is to promote your scholarship and ensure it reaches your target audience. Here’s what you can do to get started:
- Reach out to schools (e.g., high schools, colleges, universities).
- Connect with local organizations (e.g., community centers, libraries, student groups).
The final step is to select the winner and distribute the funds while following legal guidelines. Here’s what you need to do:
- Ensure your selection process is fair using an objective and nondiscriminatory basis and meets legal standards.
- Review each submission thoroughly, using your criteria to identify the most deserving candidate.
A thoughtful review and fair selection process will help you find a deserving recipient and make a meaningful impact with your scholarship.
Creating a scholarship fund benefits donors and students. Donors experience the gratification of making a lasting impact on individuals striving for education, which fosters a sense of social responsibility. For students, the benefits are life-changing. Scholarships help ease financial pressures, opening doors to educational opportunities that might otherwise be unattainable.
Tax Deductibility of Scholarship Funds
One important question to ask is whether your contributions will be tax deductible. The answer depends on how you set up your scholarship and the type of organization (e.g., scholarship management organization or nonprofit organization) you partner with. Partnering with a trusted organization also helps with tax reporting, ensuring that funds are allocated properly and used for eligible educational expenses, giving peace of mind to both donors and scholarship recipients.
Giving Scholarships Through a Foundation
Probably the easiest way to give scholarships is by donating a portion of your estate to a public or charitable foundation with a scholarship program in place. Usually, each scholarship foundation has a variety of foundation scholarship funds to choose from that cover a broad range of purposes and recipient populations. The foundations usually name a scholarship in the donor’s name or in the name of someone the donor wishes to honor, adds the donated funds to the existing program funds, manages investment of the donated funds along with the existing funds, and selects recipients according to the scholarship criteria. The donor doesn’t have to set up their own foundation or trust or worry about who is handling investments or selecting scholarship recipients.
Scholarship donations of this sort are almost always tax deductible. The donor receives an immediate income tax deduction of up to 30% of their adjusted gross income (AGI) and excess deduction can be carried forward up to five years. The donor’s estate is also reduced by the amount of the scholarship donation, so estate taxes assessed on the donor’s estate will also be reduced.
Creating a New Scholarship Foundation
Another way to give scholarships is by creating a private, non-profit organization to manage a scholarship trust. This approach allows the donor to give scholarships to specific purposes and populations that aren’t always covered by public foundations and allow the donor to designate their own criteria for determining who receives the scholarships. This approach also ensures that the people guiding the investments and selecting recipients are people the donor trusts or represent certain populations.
As long as the scholarship trust is irrevocable and the board is established as a non-profit organization, a private scholarship foundation receives the same tax breaks as a public or charitable foundation.
Giving Scholarships Through a Family Education Trust
The final way to give scholarships is through a private family education trust. A scholarship trust of this sort enables the donor to provide scholarship expressly for members of his or her family. This approach is growing in popularity to encourage and help facilitate pursuit of higher education within the family and down through generations. The donor who creates the scholarship trust can determine all the criteria for selecting recipients, define how the funds may be used, and decide how much to give with each scholarship and how often a recipient can receive a scholarship. The trust creator also assigns a distribution committee to award scholarships after the creator’s death.
Another advantage of the family education trust is that it is revocable. At any time before his or her death, the creator can decide to dissolve the trust and end the scholarship. Sometimes this is necessary to pay unexpected expenses, such as healthcare needs, toward the end of life. The primary disadvantage of using a family education trust to give scholarships to family members is that there is no tax deduction. Since the scholarship trust is revocable and isn’t part of a non-profit organization, it is not considered a charitable contribution. Therefore, no estate tax reduction or income tax deduction is available and the money is taxed a normal part of the estate.
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