Do you have to pay taxes on a scholarship? It depends what the scholarship is for. To understand taxes on scholarships, it’s worth remembering that the IRS defines qualified expenses differently for different purposes. Expenses get more or less the same treatment for taxability of scholarships as they do for education tax credits, so let’s review those.
Scholarship rules follow the AOTC rules: qualified expenses include tuition, mandatory fees, books, supplies and equipment “required for courses at the educational institution.” Scholarships that cover other expenses—“incidental” expenses such as travel and room and board—are included in gross income for tax purposes and are treated as unearned income.
Here’s where things get ugly for students receiving full-ride scholarships, many of whom receive such scholarships because of financial hardship: The new tax law that went into effect for 2018 “simplified” the kiddie tax rule. The “kiddie tax” was designed to prevent high-income parents from transferring income-producing assets to their children for purposes of reducing their taxes. Prior to 2018, the kiddie tax required that unearned income in excess of $2,100 be taxed at the parents’ marginal tax rate. The “simplification” of the kiddie tax rule was great for kids with large trust funds but terrible for low-income students receiving scholarships for incidental expenses: now these students’ scholarships, instead of being taxed at their parents’ low marginal tax rates, are taxed at trust rates which are considerably higher than regular income tax rates. For example, taxable unearned income over $12,750 is taxed at 37%. A single parent would have to have earned income over $510,300 to be taxed at that rate. So that scholarship covering room and board for a Pell Grant-eligible student is now taxed at 24% or 37%, rather than the 0%-10% rate it would have received in the past. This April, many low-income students were hit with tax bills upwards of $2500 for their scholarships. The amount, of course, depends on the scholarship and the student’s other income such as from a work study or other job.