Scholarships and 529 Plans

We have three daughters, ages 15, 13 and 11, and have accumulated about $35,000 in state-sponsored 529 college-savings plans for each of them. They are all doing very well in school and could be on the road to scholarships. What happens to our college savings if they receive full-tuition scholarships? Can we use the funds to pay for room and board?

If one of your children is fortunate enough to win a scholarship, you'd be eligible to take a penalty-free withdrawal from her 529 account up to the amount of the award. You would, however, have to pay federal and state income tax on the earnings portion of the withdrawal. To avoid those taxes, you could name another family member as beneficiary of the plan.

Not to worry, though. Even if your child gets a full-tuition scholarship, you'll probably still have plenty of other bills that qualify for tax-free withdrawals from her 529 plan -- including required fees, books, supplies and equipment. As long as your daughter attends school at least half-time, room and board count, too. And if she lives off campus, you can take a qualified withdrawal up to the cost of on-campus housing at that institution, says Doug Chittenden, head of education savings for TIAA-CREF, which administers 529 plans for many states.

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In the unlikely event that any money remained after all your children were educated, you could let them use it for grad school, use it yourself, transfer it to another family member, or take it back and pay income taxes on the earnings plus a 10% penalty.

For more information about 529 withdrawals, see IRS Publication 970 Tax Benefits for Education. For details about each state's 529 plan, see our 529 map.