If you are a student and submit a Free Application for Student Aid, or FASFA, to the U.S. Department of Education, you may receive a Pell grant award to use for some of your school-related expenses. As long as you spend the grant funds on approved expenses, the grant will not affect your taxable income. However, it will affect your ability to claim other educational tax benefits.
Tax-Free Pell Grants
The federal government issue Pell grants to help students with a financial need to pay for higher education expenses. These funds are similar to a scholarship in that you don’t need to pay it back unlike a student loan. And although the Internal Revenue Service, or IRS, generally wants you to include any money you receive during the year in taxable income, there is an exception for the Pell grants you receive. Provided you don’t use the grant to pay for certain types of expenses, you don't need to report it on your tax return.
For your Pell grant to remain tax free, you must enroll in an eligible educational institution. The IRS defines an eligible institution as one that employs a regular faculty and that consistently enrolls a number of students each year. Moreover, you need to enroll at an educational institution as a candidate for a degree or participate in vocational training that prepares you for full-time employment in a recognized occupation.
Allowable Student Expenses
In addition to satisfying the institution and program requirements, you must also use the Pell grant at the institution only to pay for certain expenses. To avoid paying income tax, you should only use the funds to pay your tuition and fees, and to purchase the books, supplies and equipment you need for your courses. Note, however, that you cannot use these funds to pay for room and board charges if you decide to go away to school. If you do, then you must report the portion of the Pell grant you use for room and board as taxable income on your tax return. Additionally, if the school refunds a portion of the grant proceeds to you because it exceeds the amount you owe, then that portion is potentially taxable if you use it for personal expenses.
Grants and Credits
One way in which the receipt of a tax-free Pell grant affects your tax return is with educational credits. Generally, both the American opportunity and lifetime learning credits provide a dollar-for-dollar reduction of your tax bill for some of your school-related expenses, such as tuition and fees. However, when you use tax-free funds, such as Pell grants, to pay your tuition, the IRS doesn’t allow you to include those costs in your credit calculation. This doesn’t mean you are entirely ineligible for a tax credit; but to claim it, you must pay some school expenses with other funds that aren’t tax free.