A scholarship is not automatically tax-free. Under IRC §117, a degree candidate excludes the award from income only to the extent it pays qualified expenses — tuition, required fees, and the books, supplies, and equipment a course requires. Every dollar spent on room, board, travel, or optional equipment is taxable, and so is any portion that is really payment for teaching or research (a teaching or research assistantship stipend), even when the money goes straight to tuition. Whoever receives the taxable portion reports it on their own return — the student, not the parent — on the wages line with the notation “SCH,” regardless of who claims the student as a dependent. The narrow exceptions are National Health Service Corps and Armed Forces Health Professions scholarships, which stay tax-free despite the service requirement.
Scholarships do not break dependency. A common worry is that a large award disqualifies the parents from claiming the student. It does not. Under the support test of IRC §152, “Dependent defined”, a scholarship received by a student who is the taxpayer’s child is ignored in determining whether the student provided more than half of their own support. A full-time student under 24 therefore stays a qualifying-child dependent no matter how generous the scholarship, and the parents keep the dependency, the education credits, and the other child-related benefits. The award changes who reports the taxable slice; it does not change who claims the student.
The earned-versus-unearned trap. Taxable scholarship income wears two hats, and the mismatch is where families get surprised. For the standard deduction, a taxable scholarship counts as earned income, so a dependent student’s standard deduction climbs to cover it — up to the full $16,100 single figure in 2026 — and most modest taxable awards are sheltered outright. For the kiddie tax (section “The Kiddie Tax and Custodial Accounts”), the same non-service scholarship is treated as unearned income under IRC §1(g). The consequence: taxable scholarship beyond what the standard deduction absorbs is taxed at the parents’ marginal rate, not the student’s. Genuine assistantship wages escape this entirely — they are ordinary earned income on a W-2 and never touch the kiddie-tax computation.
Deliberately taxable scholarships: the AOTC play. The most valuable move runs the logic backwards. For a dependent student, the American Opportunity Tax Credit (AOTC, worth up to $2,500 under IRC §25A) is claimed on the return of whoever claims the student — the parents — and the same tuition dollars cannot both be paid by a tax-free scholarship and counted toward the credit. When a scholarship is unrestricted (its terms allow use for living costs), the family can elect to treat several thousand dollars of it as taxable, freeing an equal amount of tuition to qualify for the credit. Include $4,000 of scholarship in the student’s income, free $4,000 of tuition, and the parents collect the $2,500 AOTC; the student’s tax on that $4,000 — often zero after the standard deduction, and at worst 10% — is dwarfed by the credit. Two cautions: the scholarship terms must permit non-tuition use, and if the included amount overshoots the student’s standard deduction it can ignite the kiddie tax, so model both returns before electing (section “Education Tax Credits and Anti-Double-Dipping Rules”).
Independent and graduate students. Once the student is no longer a dependent — providing more than half their own support, or simply past the age tests — the calculus simplifies. They report any taxable scholarship on their own return with no kiddie tax, and they claim the education credits themselves, subject to the income phase-outs. Graduate students typically fall outside the AOTC’s four-year undergraduate limit and lean instead on the Lifetime Learning Credit (LLTC), worth 20% of up to $10,000 of qualified expenses (section “Education Tax Credits and Anti-Double-Dipping Rules”).