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Paying for College: Is a Scholarship Considered Taxable Income?

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Dear Carrie: Does my son have to pay taxes on his scholarships and need grants in college? — A Reader

Dear Reader: I'm actually surprised this question doesn't come up more often, so thank you for raising it. For the most part, scholarship money is not considered income and is not, therefore, taxable. But as with most tax issues, a simple "yes or no" answer doesn't always apply. So, let's take a closer look.

According to the IRS (specifically, "IRS Publication 970," available online at IRS.gov), scholarships and fellowships are tax-free under the following circumstances:

— Your son is a degree candidate at an eligible educational institution.

— The scholarship or fellowship money is used for qualified expenses, which include tuition and fees, books and course- or degree-related costs (like supplies required for specific classes). This is important: Room and board, travel or other expenses associated with a college education are not considered qualified expenses and are therefore taxable. I'll revisit this idea below.

— The money does not represent wages for teaching or other work. So if your son serves as a teaching assistant, a research or lab assistant or has some other kind of job, even if directly related to the degree being pursued, that money is taxable.

For example, if your son received a $5,000 scholarship and tuition was $10,000, he would owe no taxes on the scholarship; the entire amount would be devoted to the qualified expense of tuition and fees. On the other hand, if he had a $15,000 scholarship and used $10,000 for tuition, $1,000 for books and $4,000 for room and board, then the $4,000 would be taxable income. Colleges are not required to report scholarship or fellowship income to the IRS, so it's up to your son to understand the rules and account for the money appropriately on his tax return.

However, scholarship or fellowship money that represents compensation is taxable. Let's say your son is a grad student with a fellowship worth $20,000 that requires him to be a teaching assistant or a research assistant. Some portion of that $20,000 will be considered compensation for services, and he'd receive a W-2 form from the university.

That amount is taxable income, regardless of how the money is used. In other words, even if the entire portion that represents compensation goes to tuition and other qualified expenses, the IRS considers it income — he'd be liable for taxes on that income.

These IRS rules apply to scholarships (both merit and athletic), fellowships and grants (including government-sponsored, need-based Pell Grants and others). However, there are exceptions. For example, payments made through the GI Bill are not considered scholarships and are not considered taxable income. Students participating in the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program also do not need to pay taxes on their aid. I should point out that student loans are never taxable (they could never be considered income since they have to be repaid). And remember that scholarships awarded to non-degree students are always taxable.

If you have any doubts about your son's scholarship funds, have him speak to the financial aid office; the folks there should be able to help. You may also need to consult a tax professional for specific advice. However, since tuition will be the lion's share of most students' budgets, most scholarship monies will go to pay that and other qualified expenses, resulting in no tax liability. Of course, those lucky enough to get a "full ride" from their college or university should keep track of how much scholarship money is going to qualified expenses and understand that the rest will be considered taxable income. For students with scholarships or fellowships that require employment, be prepared to receive a W-2 form and to pay taxes on that earned income.

No doubt that paying taxes on scholarships and fellowships may sting a bit. But really it's a fairly small price to pay for getting financial assistance for one of the best investments around: a college education. Good luck.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER (tm) is president of the Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

COPYRIGHT 2010 CHARLES SCHWAB & CO. INC. MEMBER SIPC

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