Merit scholarships are taxable only in part, and the split depends on how the money is spent. Under federal law, a merit scholarship paid to a degree candidate at an eligible school is tax-free to the extent it covers tuition, required fees, and required course materials. Any portion that pays for room and board, travel, optional equipment, or health insurance is taxable, and any amount you receive in exchange for teaching, research, or other services is taxed as wages. Getting the classification right also affects whether you can claim an education credit worth up to $2,500.
What Part of a Merit Scholarship Is Tax-Free
Section 117 of the Internal Revenue Code sets two conditions. You have to be a degree candidate at a qualifying school, and the money has to go toward qualified education expenses.1Office of the Law Revision Counsel. 26 USC 117 Qualified Scholarships
A qualifying school is one with a regular faculty, a curriculum, and an enrolled student body — most accredited colleges, universities, community colleges, and vocational schools qualify, along with primary and secondary schools. Degree candidates include students working toward anything from an associate’s through a doctorate.
Qualified education expenses are narrow. They include tuition and fees required for enrollment or attendance, including mandatory activity fees charged to every student, and books, supplies, and equipment required for your courses (whether purchased through the school or elsewhere).2Internal Revenue Service. Publication 970 (2025), Tax Benefits for Education
The word “required” carries the rule. A recommended laptop doesn’t qualify; software the syllabus makes every student buy does. The catalog, syllabus, and school billing statement are where you check.
What Part Is Taxable
Any scholarship dollars that pay for something outside that narrow list are taxable income. Room and board is the most common example. On a $20,000 award where $5,000 covers campus housing, that $5,000 is taxable. Meal plans, travel, health insurance premiums, and optional equipment sit in the same category.
The award letter matters as much as the spending. If the letter earmarks a specific amount for housing, that portion is taxable no matter how you actually use the funds. If the letter puts no restriction on how the money is used, you can decide which expenses it pays for, and that flexibility is what makes the credit strategy below possible.
Scholarships Tied to Work
When a scholarship requires you to teach, do research, or perform other services, the IRS treats those payments as wages rather than as a scholarship.3Internal Revenue Service. Topic No. 421, Scholarships, Fellowship Grants, and Other Grants The school reports them on a W-2, and the full amount is taxable, even if the work is a program requirement like a mandatory teaching assistantship.
One payroll-tax break helps. If you work for the same school where you’re enrolled at least half-time, and your enrollment (not the job) is the primary reason you’re there, your wages are generally exempt from Social Security and Medicare taxes under the student FICA exception. Students who receive employment benefits like retirement contributions or paid vacation are treated as professional employees and lose the exception.4Internal Revenue Service. Student FICA Exception
Deliberately Taking Some Scholarship Income to Claim the AOTC
This is where families most often leave money on the table. The American Opportunity Tax Credit is worth up to $2,500 per year for the first four years of college, and $1,000 of it is refundable. The credit is calculated on qualified expenses you paid, and every dollar of tax-free scholarship applied to tuition reduces those expenses dollar-for-dollar. The credit hits its maximum with $4,000 of qualified expenses.2Internal Revenue Service. Publication 970 (2025), Tax Benefits for Education
If your scholarship is unrestricted, you can choose to treat part of it as taxable rather than applying it to tuition. That frees up tuition dollars to count for the credit.
An example. You have $10,000 of tuition and a $10,000 merit scholarship. Exclude the whole scholarship from income and your qualified expenses drop to zero, so no AOTC. Include $4,000 of the scholarship in income instead, and you’d owe roughly $400 to $480 in federal tax at the 10% or 12% bracket, but you now have $4,000 of qualified expenses supporting a $2,500 credit. The net benefit is about $2,000.
Two limits. The move only works if the scholarship terms don’t restrict the funds to tuition. And the AOTC phases out for single filers with modified adjusted gross income above $80,000, and above $160,000 for married couples filing jointly.5Internal Revenue Service. American Opportunity Tax Credit
The Kiddie Tax Can Undo the Math
For kiddie tax purposes, taxable scholarship income that isn’t on a W-2 is treated as unearned income, even though the IRS treats it as earned for other rules like filing thresholds. If a student under 19, or under 24 and a full-time student, has more than $2,700 in unearned income, the excess can be taxed at the parent’s marginal rate.6Internal Revenue Service. Topic No. 553, Tax on a Child’s Investment and Other Unearned Income Form 8615 does the comparison and applies the higher rate.7IRS. Instructions for Form 8615 – Tax for Certain Children Who Have Unearned Income
A student with a large scholarship covering room and board can clear $2,700 easily. If the parent is in the 32% bracket, that changes the arithmetic on voluntarily including $4,000 to grab the AOTC. Run the numbers before you make the election.
How to Report Taxable Scholarship Income
Start with Form 1098-T from the school. Box 1 shows qualified tuition payments received; Box 5 shows scholarships and grants applied.8Internal Revenue Service. About Form 1098-T, Tuition Statement The 1098-T won’t capture required books and supplies bought outside the school bookstore, so keep those receipts to reduce the taxable amount.
Where you enter the taxable portion depends on the source:
- Service-based payments reported on a W-2 go on Form 1040, Line 1a, with your other wages.
- Other taxable scholarship amounts go on Schedule 1, Line 8r, which flows to Form 1040, Line 8.9Internal Revenue Service. 2025 Instructions for Form 1040
Older instructions told filers to write “SCH” next to the wages line. Ignore that. Schedule 1 now has a dedicated line for scholarship and fellowship income not on a W-2, and no special notation is needed.
If the numbers on your return don’t line up with the 1098-T, the IRS may send a CP2000 notice proposing extra tax. It’s automated, not an audit. Respond with documentation of your qualified expenses and it usually gets resolved.10Internal Revenue Service. Topic No. 652, Notice of Underreported Income – CP2000
Paying the Tax During the Year
Nothing is withheld from taxable scholarship income that isn’t on a W-2. If you’ll owe at least $1,000 at filing time and haven’t paid in at least 90% of the current year’s tax (or 100% of last year’s, whichever is smaller), the IRS charges an underpayment penalty.11Internal Revenue Service. Underpayment of Estimated Tax by Individuals Penalty
Two ways to handle it. Make quarterly estimated payments with Form 1040-ES. Or, if you have a part-time job, file a revised Form W-4 asking your employer to withhold extra from your paycheck. The second route avoids the quarterly filing.
Scholarships and 529 Plans
A merit scholarship can leave a 529 account overfunded. Normally, taking 529 money out for non-qualified expenses triggers income tax on the earnings and a 10% penalty. There’s an exception up to the scholarship amount: the 10% penalty is waived, though ordinary income tax on the earnings portion still applies.
Don’t double-count the same tuition. You can’t use one tuition payment to justify both a tax-free scholarship exclusion and a tax-free 529 withdrawal. If an $8,000 scholarship covers tuition, you need $8,000 of separate qualified expenses to support a tax-free 529 distribution. Room and board counts for 529 purposes even though it doesn’t count for scholarship purposes, which is often how families bridge the gap.
International Students Report Differently
Nonresident alien students are on a separate system. The taxable portion of the scholarship is subject to federal withholding, typically 14% for students on F, J, M, or Q visas rather than the 30% standard rate for other U.S.-source income. Reporting is on Form 1042-S instead of a 1098-T or W-2.12Internal Revenue Service. Federal Income Tax Withholding and Reporting on Other Kinds of U.S. Source Income Paid to Nonresident Aliens Many countries have tax treaties with the United States that reduce or eliminate the tax; to claim a treaty benefit, file Form W-8BEN with the school’s international student office before the scholarship is paid.
Records to Keep
The IRS can examine your return for three years after you file, so keep your scholarship file at least that long.13Internal Revenue Service. How Long Should I Keep Records? Hold onto:
- Your scholarship award letters, which show the amount and any restriction on how the funds may be used.
- Form 1098-T from the school.
- Receipts for required books and supplies, especially anything bought off campus.
- Course syllabi or registration records that show a particular item was required rather than recommended.
If you used the AOTC coordination strategy, keep a note showing how you split the scholarship. That paper trail clears a CP2000 quickly. Misreporting scholarship income can bring an accuracy-related penalty of 20% on top of the tax owed, plus interest running from the original due date.14Internal Revenue Service. Accuracy-Related Penalty