Taxes, Scholarships, And A College Freshman: No Such Thing As Free Money
Spring is nearly here, and our college-bound high school senior—like millions of others across the country—is playing two well-known waiting games. Which universities will admit her? And which will award scholarships that reduce her costs of attending?
Lesser known to many: Depending on their use, scholarships may have tax consequences. But should they, given the many subsidies for college costs built into the tax code?
A scholarship is a well-deserved price cut, awarded to inform a student’s choice of college and ease an increasingly expensive college experience.
The average full-time student pursuing a bachelor’s degree spends $27,940 a year on tuition and fees, room and board, books and supplies, transportation, and other personal expenses if they are enrolled in a public, in-state university and $57,570 if they attend a private institution. These estimated annual student budgets drive colleges’ decisions when awarding financial aid.
Sixty percent of families surveyed in 2022 used scholarships to pay for part of college, according to Sallie Mae and Ipsos. The average amount reported was about $6,000. Meanwhile, the average Pell Grant award, designed to help low-income families afford higher education, was about $4,500 in the 2019-2020 academic year (the latest available data). Scholarships and grants covered about 26 percent of student budgets, while borrowing accounted for 18 percent.
IRS rules state that a scholarship or grant is tax-free under two conditions. The recipient needs to be pursuing a degree from a qualified educational institution, and funds need to be used on qualified tuition and related expenses (QTRE), namely tuition, fees, and required books, supplies, and equipment. However, that money will be taxable if used for “room and board, travel, and optional equipment.”
It wasn’t always this way. Back in 1954, scholarships, grants, and fellowships were entirely tax-free for degree candidates through an income exclusion for tuition and fees, accommodations, textbooks, equipment, travel, and research. The Tax Reform Act of 1986 changed things when it specified that portions of scholarships used for living, travel, or research expenses would be taxable.
Other college-related subsidies in the tax code make these distinctions seem arbitrary.
For instance, a tax filer can deduct from their income up to $2,500 of interest paid in a year on a qualified student loan, no matter how a student uses the loan. The deduction is gradually reduced when a filer’s modified adjusted gross income reaches the annual limit for the taxpayer’s filing status. More borrowing might be subsidized if the Biden-Harris Administration’s student debt relief plan survives court challenges. The three-part plan forgives up to $20,000 in student loans.
Or there are tax-advantaged savings accounts. Section 529 plans offer tax-free earnings accumulation and tax-free withdrawals for QTRE and are disproportionately held by higher-income households. Their after-tax contributions can garner a state income tax deduction or credit in over 30 states. Thanks to the big budget bill signed in December, account holders will soon be able to transfer unused 529 funds to a Roth IRA, free of any tax, penalty, or applicable income limit. Then there are Coverdell accounts, similar to 529 plans but with key differences: Joint filers with adjusted gross incomes below $220,000 can deposit a maximum of up to $2,000 annually per beneficiary, and the money must be used by the time the beneficiary is 30 years old.
And there are tax credits that help families cover expenses while they or their children attend college. The American Opportunity Credit (AOTC) allows a tax filer to claim up to $2,500 per student per year in QTRE for the first four years of school as the student works toward a degree or similar credential. Likewise, the Lifetime Learning Credit allows a claim of up to $2,000 per student per year for any college or career school. If you’re a scholarship recipient, claiming either credit requires a tricky balance: Either allocate a scholarship to qualified expenses and reduce the size of the credit or allocate it to living expenses and pay taxes on it.
Amid these tax subsidies with complicated rules and qualifications, many of my friends had no idea their children’s scholarships could be taxed at all.
Last week I asked 16 of them if they knew about the potential taxability of scholarship funds. Thirteen had no idea about the IRS rules before I told them, and most did not know that they or their student should track how they use their scholarships (awarding institutions didn’t tell them).
Eleven of these friends believed that no amount of scholarship money should be taxable. Two others expressed specific concerns.
“Room and board are necessary costs to attend many colleges and universities.” Indeed, the IRS says a qualified educational institution has a “regularly enrolled body of students in attendance at the place where it carries on its educational activities.” And about half of the cost of going to college is associated with living expenses. A tax liability on scholarship funds that cover them would be an especially significant burden on students or households with lower incomes.
“Why should a book be a nontaxable use, but an optional digital device that allows you to read many books be a taxable use?” Are a phone and its data plan optional?
My friends aren’t alone in their frustration and confusion. The National Scholarship Providers Association’s Research and Advocacy Committee suggests that taxability reflects a specific policy view set with that 1986 legislation: Scholarships and grants are compensation, not a gift.
My daughter was incredulous.
“But I won’t be working for the college when I’m a freshman,” she told me. “I’ll be the college’s customer since I’ll be paying them—a LOT—to attend.”
True. Let the buyer beware.
The Tax Hound, published once a month, helps make sense of tax policy for those outside the tax world by connecting tax issues to everyday concerns. Have a question or an idea? Send Renu an email.
