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How do scholarships affect taxes

how do scholarships affect taxes

How Do Scholarships and College Loans Affect Taxes?

Linda Goin


It might be difficult for us to think about April 15th on October 13th, especially when we have holiday preparations lined up from Halloween to Mardi Gras. However, now is the best time to begin our tax preparations, especially when we have new scholarships and school loans lined up to activate throughout the school year. How will this extra income affect our taxes next year?

The school loan. provided in many cases by our local banks, and in most cases through government loans provided through FAFSA . is a binding contract that supplies money for education now with a huge debt after graduation. The major advantage to a government loan is the low interest rate. Plus, the student is granted a six-month reprieve after graduation to begin repayment. In some mitigating circumstances (like a lousy job market), the student can plead for an extension on the repayment plan. As an added bonus, the IRS does not view a school loan as income. Here's what they say:

"A school loan is not taxable at the time you get the money and should not be included as income on your return. A loan is not income because you are expected to repay the amount borrowed (plus interest). If, at a later date, any part of the loan is forgiven, the amount forgiven would be income in that year. Under certain circumstances, student loans forgiven are not income." (IRS )

School loans are advantageous for families with limited incomes, because the interest can be paid even while the student attends school. Plus, students and/or parents can opt out of the full amount granted in the loan. For instance, a graduate student that provides proof of need usually receives $18,000 per year. This amount is expected to pay for rent, food, books, classes, and other extraneous necessities and fees throughout a 12-month period. Believe me, this is difficult to budget, especially if the student doesn't work (and many grad students are restricted from work by their institutions of higher learning, especially at the doctoral level).

However, if the student is granted a scholarship, fellowship, or other financial assistance, the student may want to opt out of a portion of that $18,000 loan. This can be done! In fact, it can be done at any time during the school year for that quarter or the following quarter and even for the following year if the loan is granted for that year. But, what happens to our taxes if we opt out of the loan and accept that scholarship?

Scholarships, fellowships, and other school grants are special, because we aren't expected to repay these educational financial aids. It's like getting a huge birthday present from an unknown rich relative. Additionally, the IRS does not view any of these gifts as income IF we meet certain criteria. Let's look at the regulations for a tax-free scholarship.
  1. The student must be a candidate for a degree at an educational institution. If you are not a degree candidate, the entire scholarship/fellowship,

    etc. amount is taxable.

  • Amounts you receive as a scholarship or fellowship must be used for tuition and fees required for enrollment or attendance at the educational institution, or for books, supplies, and equipment required for courses of instruction, and
  • The amounts received are not a payment for your services.
  • The amount used for room and board is not tax-free.
  • The graduate student might be a little leery about #3, because many grad schools pay stipends to their doctoral degree students. This income is usually meant to compensate for a loss of income in pursuit of this degree; however - and a big however - this income also compensates for the teaching/assistance/ research provided by the grad student for their professors as part of this degree. So - the best option to avoid a #3 tax-paying scenario is to make sure your educational institution considers the stipend a gift, not payment for employment. See the IRS FAQ with references to further publications on loans, scholarships, and other educational funds.

    The best way to avoid a major tax headache is to rent a cheap place or stay in a dorm, and eat less-expensive fruits and veggies and avoid wallet-sucking fast-food places (and this practice is also healthier). Another tip employs the choice of jeans over designer clothes and this includes trips to used-clothing stores instead of to places that utilize high mark-ups. Additionally, check how your student (or you) fits within the IRS Hope and Lifetime Learning educational credit programs . Sometimes these credits supply a welcome break from stressful financial situations during a college career.

    What happens, though, if the student paid for books, classes, and other school-related items, and a low-budget lifestyle leaves money in the bank at the end of the year? Leftover money is not taxable if the intent is to use the money - eventually - for educational expenses. In the meantime, this leftover cash can be used to lower next year's loans, and can be used for investments which gain interest to offset the lower-interest FAFSA loans. The latter choice is fraught with taxable implications unless you opt for equities that pay out in tax-free dividends and if you don't sell the equities during the tax year. Additionally, the money used for investments may be viewed as income, unless the money is withdrawn to pay for school classes, books, etc. during the college career.

    Of course, the investment risk factor comes into play with the latter ploy, because the stock market may be bearish instead of bullish when the need to use that money arrives. The tactic to use here is diversity, where - as mentioned in last week's article - equities are balanced with compound-interest savings accounts and bonds. This practice of frugal living combined with diversified investment strategies may yields results in the long run.almost as fruitful as a good education. Students who stay in school and achieve higher degrees often make more money . We'll compare at how much more we can make and use for investments next week.

    Category: Taxes

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