Financial aid in the form of student loans, scholarships and grants can be an effective solution to all of the expenses that come with getting a college degree.

Not all financial aid is equal. Some financial aid can be considered income, while other types of funding for college is nontaxable income. It can be confusing. After sending in the Free Application for Federal Student Aid form, also known as FAFSA, and acquiring funding for college, you need to be aware of how to use that funding correctly so you don’t get dinged with fees or penalties.

Tip

Financial aid is taxable under certain conditions.

Student Loans and Taxes

Student loans can be beneficial. They help to pay for the basics so you can concentrate on school and increase your credit score if you pay on time. The IRS does not tax student loans because you must pay back the money that you have received.

The good news is that once you begin to pay back the loan, the interest that you have paid is tax deductible annually. The loan is considered income when you apply for credit cards or other bank loans.

A student loan that has been forgiven doesn’t mean you are completely in the clear. Check with the IRS that you don’t owe taxes on the forgiven amount. The IRS will send a 1099-C form if it is aware that you had a loan that was forgiven and owe taxes on that amount. A tax professional can help clear up any confusion regarding a student loan.

Student Grants as Income

The IRS has specific guidelines as to what is considered income when it comes to student grants. FAFSA funds that are used to pay for IRS-qualified education expenses at an accredited institution are tax free.

You must be currently enrolled in the school at the time that the funds are used, otherwise the received financial aid is taxable.

Expenses that qualify as tax free with the IRS include:

  • Tuition
  • Education-related fees and course-related expenses such as textbooks

Financial Aid Is Taxable

It can come as a surprise at tax time when you find out that you owe money on the financial aid that helped you all year long. What doesn’t qualify as tax-free income from FAFSA grants is any funding you use to pay for living expenses, rent or any room and board.

To be clear, the grant money can only be used to buy needed school supplies. If your syllabus states that one textbook is needed but the professor recommends three more, only the required book for the class is nontaxable. Grant funds used for any recommended books, apps, programs or other suggested instruction will need to be stated on your taxes as income.

If you are lucky enough to have funds left over after paying the tuition, buying all the expensive textbooks and other requirements that come with attending classes, then you need to set aside some of that windfall for the IRS.

Tips for Taxable Financial Aid Funds

Grants and loans are good tools for students to be able to focus on school rather than carrying a job along with a full course load. They can also feel overwhelming if you worry about going into debt.

A good rule of thumb is to stash 25 percent of the extra money you have left over from financial aid in a savings account. This should be enough to pay for the taxes on the portion that you will use for things other than schooling. By storing a portion of the leftover funds before taxes are due, you can be better prepared to pay them.

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