Scholarships, Fellowships, Grants, and Tuition Reductions
The federal government helps to subsidize education by providing tax credits and allowing deductions for qualified educational expenses. However, the deduction for higher education tuition and fees is only available for those who do not claim an American Opportunity or Lifetime Learning credit. United States savings bonds may also provide some tax savings if used to fund education. Most of the tax credits and deductions do not apply to graduate school, but tuition reductions for graduate studies can be tax-free if, in exchange, the taxpayer teaches or does research for the institution.
Most tax-free income and allowable deductions are only available for courses leading to a degree or a recognized occupation. The degree test is met by taxpayers attending primary or secondary school or a college or university, in addition to those institutions that offer training for students in a recognized occupation in which the institution is authorized under federal or state law to provide such a program and is also accredited by a nationally recognized accreditation agency.
Scholarships, Fellowships, and Grants
Scholarships, fellowships, and grants — including Fulbright grants — are tax-free to students enrolled in a degree program in an eligible institution to the extent that the grants are used to pay for tuition and course-required fees, supplies, books, and equipment. If the taxpayer is not working for a degree, then the entire payment is taxable. Athletic scholarships may also be tax-free if they satisfy these requirements. However, room and board, travel, and other incidental expenses are not qualified expenses, so any payments for these expenses by the educational institution are fully taxable.
However, any scholarship, fellowship, or grant that is a payment for services provided, as well as scholarship prizes, is taxable. So if you receive $3000 scholarship, for which $1000 is paid for teaching services that you provide, and the remaining $2000 is used to pay for qualified expenses, then the $2000 is tax-free while the $1000 paid for teaching is taxable.
Because Pell grants and other Title IV need-based education grants are paid based on need rather than for any services provided, they are tax-free to the extent they are used to pay for qualified educational expenses.
Any payments received for training, education, or subsistence under any law administered by the Department of Veterans Affairs (VA) are tax-free. VA paid educational expenses are ineligible for other tax benefits, so qualified educational expenses must be reduced by the amount of the VA payments before calculating the other tax benefits. So if a student qualifies for the American Opportunity Credit, and she has $3000 of qualified expenses, for which he receives $2000 of VA payments, then the American Opportunity Credit can only be applied to the remaining $1000 of qualified expenses.
Although grants or tuition reductions paid in exchange for services are taxable and subject to withholding, payments for services are tax-free if paid by the National Health Services Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program, and if the taxpayer is a degree candidate at either of the institutions and that part of the payment for providing a service is used to pay for qualified educational expenses.
If qualified educational expenses are reduced by other tax benefits, then those expenses must be reduced by the amount of the benefit to determine how much of the qualified expenses are eligible under these rules.
The recipient of a tax-free scholarship or fellowship does not have to file a tax return for that income. If the student must report taxable income, then it is entered on the line for wages, compensation, and tips, on whichever tax form the taxpayer files to report income, such as Form 1040, U.S. Individual Income Tax Return, and the taxpayer should write "SCH" on the dotted line next to the box listing the income.
Tuition reductions for college employees are not taxable if they provide free or partially free undergraduate education, whether at the school of the employee or another school. These tuition benefits are also available to the employee's spouse, dependent child, the widow or widower of an individual who died while employed by the school or to a retired or disabled employee or to the spouse or dependent children thereof, or to a former employee who retired or left on disability. A dependent child of divorced parents is considered a dependent of both parents in regard to the rules for the qualified tuition reduction. However, any tuition reduction program must be nondiscriminatory — it must not discriminate in favor of owners, officers, or highly compensated employees.
A tuition reduction for graduate school is tax-free if provided by an eligible educational institution and the graduate student receives a grant in exchange for providing teaching or research services. Hence, graduate school is an exception for the general rule that payments for services are taxable.