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Could I Owe Taxes on College Scholarships?

By College Planning Credit.com

Paying for college isn’t getting any cheaper, so in order to avoid going into unaffordable education debt, families and students either need to save more money, go to less expensive schools or find someone else to pay for it.

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There are hundreds of thousands — maybe even millions — of scholarship opportunities out there, but receiving monetary awards can do more than affect your financial aid situation. It may also affect your taxes.

Defining ‘Scholarship’

Whether or not a scholarship is taxable depends on a few things, mostly on how you receive it. A lot of schools give students discounts on tuition and fees and call it a scholarship, but the institutions aren’t really giving students money to help pay for school; they’re just charging them less.

That sort of scholarship isn’t taxable, said Elliott Freirich, a certified public accountant in Chicago. It sill affects the scholarship recipient’s taxes, because reduced tuition may mean a reduced amount of education credit he or she can claim.

If a school is actually giving you money, that changes things. Such a situation often comes up in graduate programs, when students sometimes receive stipends for work they do at the university or to cover living expenses during a demanding, time-consuming program. Stipends are taxable and should be reported as Form W-2 income, Freirich said. In his experience, however, that doesn’t always happen.

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“Universities often screw up how it’s reported,” he said. “In some cases, they have reported it as self-employment income, which means the student is going to have to pay both halves of Social Security and Medicare on that income.” He’s also encountered students who didn’t receive any tax forms from their universities — just letters stating the stipend amount — and it’s up to the student to figure out the tax part.

“I would ask for a tax document first,” Freirich said. “Ask for some kind of official documentation from the school, and if the school doesn’t know … find a good CPA to help you.”

How to Handle Checks

Sometimes, a scholarship program will dole out awards by paper check directly to its recipients. From a tax perspective, there are two things to consider when you receive a scholarship: What you're using it for and how you're receiving it. If you use the money to pay for tuition, fees books, supplies or equipment required for enrollment at your institution, the scholarship is tax-free. It's paying for optional expenses (anything you're not required to pay for in order to be enrolled) when your scholarship would be subject to taxes.

If you receive and deposit the check, and you use the funds to pay for optional education-related expenses, you are required to claim that check as taxable income, Freirich said. However, if the scholarship program sends the payment directly to the school, essentially paying on your behalf, you never receive that money and do not pay taxes on it.

"The school just issues a document called a 1098-T, and it shows how much is paid for tuition and how much is a scholarship, but it doesn’t say 'This much was for room and board and is taxable,'" Freirich said. (Room and board can get tricky with scholarships, because if it's not required for enrollment, it could be considered an incidental expense and subject to taxes). The key here is to communicate with the scholarship provider and make sure you understand how the funding will be delivered.

Scholarships are a fantastic resource for students looking to reduce how much they pay for their educations. They’re generally quite competitive, which is why financial aid experts often recommend applying for as many as you can and treating the scholarship search-and-application process like a job. The less of your education you have to finance with student loans, the better, because while student loans can be a good resource for making higher education attainable for people of various financial backgrounds, the debt can be a serious, lifelong burden if it’s mismanaged. Student loan debt can generally not be discharged in bankruptcy, and falling behind on loan payments will destroy the borrower’s credit for years. You can get a free credit report summary on Credit.com to see how your student loans are impacting your credit.

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(This story was updated to clarify the tax implications when scholarship checks are sent to students and used for required versus optional education related expenses.)

This article originally appeared on Credit.com.

Christine DiGangi covers personal finance for Credit.com. Previously, she managed communications for the Society of Professional Journalists, served as a copy editor of The New York Times News Service and worked as a reporter for the Oregonian and the News & Record. More by Christine DiGangi