Financial aid for college comes in many forms—and each can have different tax implications. Congratulations! If someone in your family recently secured a scholarship or financial aid package, it’s a huge win toward offsetting the rising cost of higher education.

However, with the fall semester around the corner, an important question arises: Are those benefits taxable?

Navigating the answer can feel like it requires a Ph.D. In a recent Wall Street Journal article on the topic, Lisa Heller, chair of the AICPA’s tax-exempt organizations committee, highlighted the challenge:

“It’s very hard for students and parents to parse what financial assistance is taxable and what isn’t.”

Key Tax Implications for Families

• The Kiddie Tax Risk: For affluent households, this distinction is crucial. Taxable financial assistance may be taxed at the parents’ higher tax rate rather than the student’s lower rate.
• Limited Standard Deduction: If the student is claimed as a dependent, their standard deduction may be significantly restricted.
• Education Credit Phase-Outs: The American Opportunity Tax Credit (worth up to $2,500 per student) may not be available if household income exceeds the phase-out limit (which begins at $160,000 for married couples filing jointly).

Why Form 1098-T Isn’t Enough

Colleges issue Form 1098-T (Tuition Statement) to both the IRS and students to report tuition paid and scholarships awarded. However, Heller cautions that these forms rarely tell the complete story. They frequently omit outside awards and fail to distinguish which specific funds qualify as tax-exempt versus taxable income.

Careful planning can also lead to tax savings. Mark Kantrowitz, a Chicago-based financial-aid specialist, told the Journal that it often makes sense to put scholarships and other aid toward tuition specifically. That’s because such funds are typically tax-free when applied to tuition, but taxable when used to cover living expenses.

If a scholarship or other financial aid has brought good news along with the headache of navigating complicated tax rules, here’s some help.

Know what’s tax-free and what’s taxable

As long as the school meets the requirements laid out in IRS Publication 970, money from scholarships, grants, fellowships, and certain fee waivers is generally tax-free when it goes toward tuition. The same usually holds true for required fees, books, supplies, and equipment.

The operative word is “required.” If a student uses scholarship money to buy a computer that isn’t a required item, that portion is likely taxable.

Other forms of aid are typically taxable, including funds put toward room and board, most travel costs, and optional expenses. Money paid to a student for work, such as an office job, is also generally taxable, as are stipends meant to cover living expenses. (This income may show up on a 1099 or W-2.)

Student loans, by contrast, don’t count as income. For a clearer picture of what applies to a specific bill, it’s worth asking the bursar’s office to break it down.     

Understanding the Limits of Form 1098-T

Colleges and universities are required to send Form 1098-T to both students and the IRS.

• Box 1: Reports payments received for qualified tuition and related expenses.
• Box 5: Details the total scholarships or grants administered by the institution or reported through select third parties.

The Reporting Blind Spots    

1. Taxable vs. Nontaxable Breakdown Is Missing: Form 1098-T does not indicate whether aid funds are subject to taxes. If scholarship money is applied toward room, board, or general living expenses, tracking and calculating that taxable portion falls entirely on the student and parents.
2. Outside Assistance Isn’t Tracked: Independent scholarship providers, private foundations, and stipend issuers generally aren’t required to issue a 1098-T. Families must independently track and report all outside financial assistance.

Where to find guidance: For detailed instructions on calculating and reporting taxable aid, refer to IRS Publication 970 (Tax Benefits for Education) and IRS Tax Topic 421 (Scholarships, Fellowship Grants, and Other Grants).

Time Your Payments Carefully

To avoid tax complications, financial expert Mark Kantrowitz advises matching scholarships, fellowships, and other financial aid directly to the tax year in which the expenses occur.

• The Calendar-Year Dilemma: Universities often bill for the spring semester in December. If a student receives a fellowship or financial aid package for a term starting in January, paying the bill in December can create a tax mismatch.
• The Solution: Wait until January to pay the bill so that the costs, financial aid, and actual transactions all fall within the same calendar tax year.

Coordinate Financial Assistance and 529 Withdrawals

Tax-favored 529 education savings accounts offer a powerful way to reduce college costs, as withdrawals for eligible higher education expenses are completely tax-free. Because 529 rules are often more flexible than those governing scholarships and grants, strategic coordination can yield significant tax savings:

1. Avoid Double-Dipping: The IRS does not allow you to claim a tax-free 529 distribution and an education tax credit (like the American Opportunity Tax Credit) for the exact same expense.
2. Align Distribution Dates: Ensure 529 withdrawals are taken in the exact same tax year the qualified expenses are paid.
3. Offsetting Scholarships: If a student receives a tax-free scholarship, you can withdraw an equivalent amount from a 529 account without paying the typical 10% penalty, though income taxes will still apply to the earnings portion.    

For example, 529 withdrawals used for room and board can be tax-free as long as the student is enrolled at least half-time, which isn’t the case when scholarship money is used for those same costs. Withdrawals are also tax free when they go toward a computer, software or internet access that isn’t required by the school but is mainly used for schoolwork. Students living and eating off campus can use 529 money for rent and groceries too, usually up to limits similar to what the school charges for room and board.

If you’re working with a mix of scholarship and 529 funds, there’s more to think about. Up to $10,000 per student in 529 money can go toward paying off student loans, and 529 funds can be used for graduate school as well as undergrad.

On top of that, up to $35,000 in 529 funds can be rolled over into a Roth IRA for the student who’s the beneficiary of the account. There are some catches, including that the beneficiary has to qualify for a direct Roth contribution in the first place. The IRS still hasn’t put out full guidance on this rule, but plenty of taxpayers are already using it.

Don’t stress too much about IRS enforcement

If all of this feels like a lot to untangle, take a breath. Kantrowitz and other specialists say they’ve seen very little actual IRS enforcement in this area. So if you’re making a genuine effort to follow the rules and keeping decent records, you’re probably in good shape.