Scholarships and fellowships are nontaxable, says Internal Revenue Service (IRS) spokesperson Nancy Mathis, as long as you are a candidate for a degree at an institution that meets the IRS eligibility requirements (available in Publication 970) and use the money for:
Tuition and fees required for enrollment or attendance.
Fees, books, supplies and equipment required for your courses.
Any portion of the money used for other purposes, such as room and board or optional computer software, is taxable. Moreover, the entire scholarship or fellowship is taxable if you won the money through a contest that does not require you to use it for your education.
For example, George Washington University clinical psychology student Mary Politi had a $10,000 fellowship toward her $18,000 tuition as a first- and second-year student; she paid no taxes on the fellowship because all the money went toward tuition. As a fourth-year student this year, she has a fellowship that covers her dissertation credits and includes a stipend for living expenses, so she'll owe taxes on the stipend.
The situation can get more complicated when students also work for their university, since payments they receive for performing a service-such as being a graduate teaching assistant-are taxable. Here's a hypothetical situation from the IRS:
Gary Thomas, a degree candidate, receives a scholarship of $2,500 for the spring semester that requires him to be a part-time teaching assistant. Of the $2,500 scholarship, $1,000 is earmarked as compensation for his teaching. That means Gary can deduct $1,500 of the scholarship from his income, but the other $1,000 is taxable.
However, while that $1,000 is technically taxable, students performing services at their university are usually exempt from the Social Security and Medicare withholdings (also known as FICA taxes). The IRS Web site-www.irs.gov-includes information on determining your status.
The key, students say, is to keep careful records-such as receipts, scholarship letters and bank statements-about where the scholarship or fellowship money came from and how you used it. Then, if you're ever audited you'll have proof, for example, that you put the scholarship money toward tuition and not living expenses.
—D. SMITH BAILEY