529 Plans and Scholarships

As a followup to my recent post on common misconceptions about 529 plans, I just wanted to highlight an additional way to get unspent money out of the account without paying taxes or penalties. A sharp-eyed reader named Courtney asked:

I’ve heard that if your child obtains a scholarship, you can withdraw that amount from the 529 plan without paying the 10% penalty. Is that true?

529 Plans and ScholarshipsThe last thing that you want is to save diligently for your child’s education, only to be penalized when they receive a scholarship and don’t need all of the money that you’ve socked away. So… What’s the deal with scholarship and 529 plans?

As it turns out, the typical 10% penalty on non-qualified distributions is waived when withdrawals can be attributed to a scholarship that the beneficiary has received. More specifically, section 530(d)(4) of the Internal Revenue Code states that this penalty exception applies to distributions made “on account of” a scholarship.

What’s less clear is when you have to take the distribution to qualify for penalty-free status. Do you need to take the withdrawal during the year in which the scholarship was awarded, or can you wait until later? The IRS hasn’t provided any clear guidance on this question.

While you you won’t have to pay the penalty for a scholarship-related withdrawals, however, you will have to pay income tax on the earnings portion of your withdrawal. Of course, even if your kid gets a major scholarship, they may have enough other education-related expenses to draw down your 529 savings plan.

7 Responses to “529 Plans and Scholarships”

  1. Anonymous

    Hi Rosa,
    I guess what I’m trying to portray here is that somehow we have mixed up saving and investing. In my mind, savings should be safe, liquid, and under my control.

    To me, retirement plans like the 401k and 529 are more investments rather than savings accounts. With the 529 plan, there are no guarantees as we have seen with people taking hits on their 401k plans.

    The money isn’t liquid. Sure, some say you shouldn’t touch that money, but if I have to make a decision between keeping money in the 529 plan and saving my home, I think I’d have to save my home. Then I get penalized if I access it for this reason.

    For me, it lacks the features I would like to have for a “savings account” for my child’s education.

  2. Anonymous

    Thank you for following up on this! It’s excellent info, and I didn’t know.

    Bern, our 529 can be used for any kind of education including trade school, private high school, and study abroad programs.

  3. Anonymous

    I’ve found that the 529 plan only has one purpose, saving for college. Nowadays, kids not going to college isn’t all that uncommon.

    Plus, you can get double taxed if the funds are not used for college related expenses, it affects your financial aid, and the account is subject to market trends. There are no guarantees.

    Be sure you are aware of the ins and outs before enrolling into the plan.

  4. Anonymous

    @Nickel: Yes, that’s what I was asking, and that’s also what I figured.

    Good to know that there is a backout option. I’ve set up a 529 for my daughter, but (as all parents would) I want/hope/dreams that she gets a full scholarship somewhere. We’ll just have to see. It’s 18 years from now.

  5. Anonymous

    Thanks for the additional information. Like I had said in another comment, it made logical sense but I don’t count on the government to do anything logical…

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