Coordinating Scholarships and 529 Plans

CPAs & Advisors

Kelly Brown
Kelly Brown CPA, MST Tax Supervisor CPAs & Advisors

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For 18 years, you have carefully saved for your child’s education using a 529 plan, accumulating a sizable sum, but your child has earned a scholarship or two—so now what? First of all, congratulations, both you and your child have much to celebrate! But now what should you do with the extra 529 funds to minimize penalties and tax?

First, note that section 529 funds can be used for more than just tuition and fees—other expenditures qualify too. This includes textbooks, internet expense, a computer and any software used primarily for education. And then there is the big one, room and board for your student if attending at least half time.

Not living on campus? No problem! Colleges and universities annually publish a “cost of attendance” calculation for each school year, which details the approximate amount of room and board. You may make tax-free distributions from a 529 plan up to this amount for a student not living on campus. For students actually living on campus, if this price exceeds the quote in the cost of attendance, the actual amount spent may be distributed.

Still going to have funds left? There are a few other options. First, if there is another child you would like to name as the beneficiary, the accounts may be transferred between siblings, or even to a spouse or first cousin, but make sure that the beneficiary has changed before making distributions for the newly appointed student, or this can cause you tax headaches down the road.

If there is no other potential beneficiary, any excess amounts up to the amount of scholarships earned may be withdrawn without penalty; however, any earnings on the withdrawal would be subject to tax. See the following example:

Sam has a scholarship that pays for all tuition annually, which is expected to be $10,000. Sam’s parents have saved diligently and, even after making withdrawals for room and board, they are expecting to have $40,000 left over in the account, as it was the amount anticipated for tuition ($10,000 x 4 Years = $40,000).

In year one, $10,000 above the amount for room board and other expenses is withdrawn. The 10% penalty does not apply, as Sam has scholarships of $10,000, which is what caused the overfunding in the 529 plan. At the time of withdrawal, 60% of the account is contributions, 40% is earnings. As the beneficiary of the account, Sam will pay income tax on the $4,000 in earnings that are withdrawn.

In year two, $11,000 (55% contributions, 45% earnings) above the amount for room and board and other expenses is withdrawn. Sam incurs $10,000 in tuition and fees, all of which is covered by a scholarship. In this case, the earnings portion of $1,000 ($1,000 x 45%=$450) of the $11,000 is subject to a 10% penalty for being a distribution in excess of the amount of scholarship covered expenses, which in this case would be $45 ($450 x 10%). $4,950 ($11,000 x 45%), the amount of earnings from the distribution, is also subject to income tax.

Fortunately, students are often in a lower tax bracket, which lessens the tax sting somewhat. If you will make 529 plan distributions, check with your tax professional to set the best course to minimize the tax implications of distributions, along with maximizing any educational credits for which you may qualify.

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