Why Winning Free Tuition from a Contest Costs You More Than You'd Think

Parents and children alike both know that in order to attend college, the first hurdle is to get accepted -- the second is piecing together enough money to afford it.

While, there are tax-advantaged programs parents can use to preemptively save for their children's higher education expenses, many students rely on assistance from Federal Student Aid. The Office of Federal Student Aid, which offers more than $150 billion dollars to students in the form of grants, loans, and work study funds, affords "gift aid" (free money) to students based on need and merit.

Many students want gift aid, and who can blame them? Though federal student loans often have lower fixed interest rates, federal grants don't have to be repaid at all. However, many students simply don't qualify for one hundred percent free aid. As of late, though, another type of "gift" aid has been cropping up, and you may have even seen it marketed in your email box -- flashy tuition aid from corporate contests.

Is it just a marketing scheme?

Big companies like Dr. Pepper and American Eagle Outfitters have come forward to offer up thousands of dollars in college tuition.

American Eagle's "Sweepstakes Grand Prize consists of college tuition awarded specifically as a check in the amount of $25,000." Dr. Pepper's Tuition Giveaway allows students to compete for a grand prize of $100,000 dollars.

These tantalizing awards beg the question -- is the money really free?

Experts weigh in

It's difficult to know how to qualify free college tuition -- upon first glance, it seems it could fit into four categories: lotteries, sweepstakes, educational assistance, and scholarships. However, according to tax experts, the IRS will emphasize the fact that they are prizes.

"The IRS wants their share of your contest winnings. If you win tuition you can expect to pay income tax on the value of the prize winnings," says David Reicher, Esq at LegalAdvice.com. "Your tax obligation becomes due when filing your taxes for the fiscal year on April 15th. Theoretically, the contest organizer could withhold the portion of taxes due and distribute to the IRS on your behalf but that is unlikely."

Research on the IRS site goes a step further in clarifying the specifics: "Scholarship prizes won in a contest are not scholarships or fellowships if you do not have to use the prizes for educational purposes. You must include these amounts in your income on Form 1040, line 21, whether or not you use the amounts for educational purposes."

Natasha Rimba, a tax accountant at Deloitte, specifies the differences between scholarships and sweepstakes winnings. "The quick and dirty answer is that you will get taxed for this because it will qualify as a prize. It's generally tax-free if you get a scholarship through your school. For example, let's say you get a scholarship from Fordham University -- this scholarship is tax free because it is only for tuition and books. If your scholarship includes room and board, the room and board is taxable."

Any portion of scholarship or grant money used for room and board, travel, or optional equipment is taxable and is required to be included in your gross income, another way in which winning free tuition costs you. You can use Worksheet 1-1, Taxable Scholarship and Fellowship Income to calculate those amounts.

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How they measure up

As Reicher earlier predicted, the official rules of American Eagle Outfitters has transferred the tax responsibility of the $25,000 grand prize to the Sweepstakes grand prize winner. "All federal, state, provincial and local tax liabilities, if any, are the responsibility solely of the prize winners."

Additionally, the company states the grand prize winner will receive a year's worth of tuition, but caps it at a dollar amount and issues the "tuition" in the form of a check. The IRS will most likely see the check as income.

Dr. Pepper, on the other hand has closed their contest for the 2014 year, but writes that they will be giving more tuition out in 2015. Their contest, unlike American Eagle Outfitters, is not a random drawing, but focuses on "one-of-a-kind" stories. This picture indicates that their winners are awarded tuition in the form of a check.

What to do in a situation like this

According to Joshua Duvall, an Insurance & Social Media Specialist at Capital Financial Service, LLC, the best approach to a unique situation like this is to ask the company for a 1099 for the $25,000, and prepare to file taxes immediately, because depending on the state, you may be required to file taxes early (California requires its residents to pay state taxes early). "I would recommend calculating the tax ahead of time, and setting aside that portion of it, so that come tax time you have the money on hand to pay the bill. If you still have a few years before you start college, you could consider opening a 529 plan with the money," advises Duvall.

Turning to federal aid

If you aren't the lucky student winning an entire year or more in tuition money, you can apply for non-need based aid. However, if you procrastinate, you may only have the option of Federal Aid to fund your college expenses.

Though student loans can add up to be a gargantuan sum, federal student loans offer a variety of excellent benefits that make repaying them much more reasonable and stress-free. As we stated earlier, federal student loans often have lower fixed rates, and when the time comes for you to begin repaying your federal student loan, your loan servicer will work with you to come up with the best payment plan for your specific needs, which includes the possibility of income-based repayment (in which you would not have to begin payment on your loan until you begin earning income).

Also you'll have options to consolidate your eligible federal student loans into one, deduct student loan interest on your taxes, and be forgiven for all your loans if you occupy certain types of employment. A work study job can also supply you with funding you can use towards your tuition.

It's important to know that if you enter a contest and win "tuition," you're most likely winning a cash prize that will be taxed as income. However, by being smart and setting a portion of tuition winnings aside for tax season, you can pay Uncle Sam and keep the rest to fund your education.