If your or your college-age child is or will be receiving financial aid to help cover educational costs, then you probably want to know if this is taxable.

Keep in mind that the economic characteristics of financial aid, rather than how it is titled, will determine its taxability. Strictly speaking, scholarships, fellowships, and grants are usually awards of “free money” that are nontaxable. However, these terms are also sometimes used to describe arrangements involving obligations to provide services, in which case the payments are taxable compensation.

Tax-free awards. Scholarships, fellowships, and grants are awarded based on the student’s financial need or are based on scholastic achievement and merit. Generally, for federal income tax purposes, these awards are nontaxable as long as (1) the recipient is a degree candidate, (2) the award does not exceed the recipient’s “qualified tuition and related expenses” (tuition and enrollment fees, books, supplies, and equipment required for courses, but not room and board or incidental expenses) for the year, (3) the agreement does not expressly designate the funds for other purposes (such as room and board or incidental expenses) or prohibit the use of the funds for qualified education expenses, and (4) the award is not conditioned on the student performing services (teaching, research, or anything else).

Work-study arrangements. If the financial aid is conditioned on the student performing services, the amount that represents payment for such services is taxable income and will be reported on a Form W-2 or Form 1099. This is true even if the work is integrated with the student’s curriculum or if the payment is called a scholarship, fellowship, or grant. Students typically work for the school they’re attending. However, they could work for other employers under the auspices of a work-study program.

Student loans. Naturally, student loan proceeds are not taxable income because the borrowed amounts must be paid back. However, some college education loans are subsidized to allow borrowers to pay reduced interest rates. Fortunately, college loan interest subsidies are nontaxable to the same extent as if they were provided in the form of an outright scholarship, fellowship, or grant. An above-the-line deduction (i.e., available whether or not the borrower itemizes) of up to $2,500 is allowed for interest expense paid by a taxpayer on a loan to fund qualified higher education expenses. The deduction is phased out for taxpayers with adjusted gross income exceeding certain amounts.

What happens when financial aid isn’t free? Fortunately, taxable scholarships, fellowships, grants, and compensation from work-study programs count as earned income. Assuming the student is your dependent, this means that for 2015 he or she can offset this income by his or her standard deduction of the greater of (1) $1,050 or (2) earned income plus $350, up to $6,300. Since taxable scholarships, fellowships, grants, and compensation count as earned income, they increase the student’s standard deduction. If the student isnt anyone’s dependent for 2015, he or she can offset earned income of up to $10,300 with his or her personal exemption ($4,000) and standard deduction ($6,300). (Dependents are not entitled to a personal exemption.)

Taxable financial aid in excess of what can be offset by the student’s personal exemption (if any) and standard deduction is usually taxed at only 10%. (For 2015, the 10% bracket for single taxpayers applies to taxable income up to $9,225.)

Warning: The “kiddie tax” rules may cause investment income (such as interest, dividend, and capital gains) received by students who are under age 24 to be taxed at the parent’s higher rates instead of at the student’s lower rates. The student’s earned income (including taxable scholarships, fellowships, grants, and compensation) is not subject to the kiddie tax.

Holbrook & Manter can provide you with more information on this topic, and help you make sound financial decisions when it comes to funding education. Contact us today.