Are Scholarships Considered Taxable Income?

Getting a good education can be a smart career investment, but it often comes at a price. Tuition and fees cost thousands of dollars and sometimes require the use of student loans. To help pay these costs, students often look for scholarships -- financial awards that help pay for school. Most of the time, these scholarships are tax-free -- they qualify as benefits that aren't subject to federal income taxes. It's important to know the difference between scholarships that are taxable and those that are not, because failing to pay taxes when required to do so carries serious consequences.

Generally speaking, the federal government does not consider scholarships and fellowships for education to be taxable income. There are some notable exceptions to this rule, though, and it's important to remember that failing to report a taxable scholarship -- or counting a taxable scholarship as nontaxable -- can result in penalties and interest charges. Scholarships are only nontaxable if they're applied to tuition, fees, books, supplies or equipment. Additionally, scholarships are nontaxable if the student receiving them is pursuing a degree at an accredited college, university or technical school. Scholarships to private primary and secondary schools are also tax-free.

Scholarships are considered taxable if they pay for nonqualifying expenses or for services rendered by the recipient. Scholarships for nonqualifying expenses are liable for income tax even if the expenses they cover are qualified for school attendance. Nonqualifying expenses include housing, food and travel costs. They also include any supplies, books, fees or equipment that are not required of all students in the particular school or course the student is attending. Scholarships that are considered compensation are also subject to taxes.

Most forms of government assistance that help to pay for education are nontaxable. Students who receive a Fulbright scholarship, a Pell Grant or another need-based education grant are required to report this assistance only if it pays for nonqualifying expenses like food, housing or travel costs. Education payments from the Veterans Administration are fully tax-free, even if they pay for nonqualifying expenses like housing. Assistance from state or local governments that pays for a job-training program is nontaxable if it is considered a regular welfare benefit.

In addition to scholarships, the government helps students pay for college with tax credits and deductions. The American Opportunity Credit, for example, allows students or their parents to claim up to $3,600 in tax benefits as of February 2011 to help offset the costs of tuition and school supplies. Alternatively, the student or her parents may deduct up to $4,000 education expenses on a tax return. They may not claim both education credits and the tuition and fees tax deduction. Taxpayers cannot deduct or claim credits for tuition or other expenses that were paid for by a scholarship.