The 529 Plan Scholarship Exception
You can withdraw up to the amount of a scholarship from your college savings plan without paying a penalty.
My daughter was awarded a full scholarship to college, but we’ve been saving for college for years in a 529 plan. Now I’m wondering what’s going to happen to that money. Is there any way that I can get the money out of the 529 without penalty?
Congratulations on your daughter's scholarship! When you take money out of a 529, earnings and contributions are withdrawn proportionately. Usually, you'd owe income taxes and a 10% penalty on earnings that aren't used for qualified education expenses. But you can withdraw money from a 529 up to the amount of a tax-free scholarship without paying the 10% penalty. You still have to pay income taxes on earnings, but contributions can always be withdrawn tax- and penalty-fee. See whether your 529 administrator will let your daughter take the withdrawal herself, listing her name (rather than yours) on the Form 1099 that reports the withdrawal to the IRS. She would then be responsible for paying the taxes, but that can help lower the tax bill because she’s likely to be in a lower bracket than you are.
You still may be able to find some qualified expenses that you could use the 529 money for and avoid some of those taxes. In addition to tuition, you can use 529 money tax-free for room and board, books and mandatory fees (see Using 529 Funds to Pay Rent for the rules on 529 withdrawals if she lives in an off-campus apartment). And if your daughter ends up going to graduate school, she can use the money for tuition, room, board, books and mandatory fees there, too (there’s no age limit for using the money).
Another option: Switch the beneficiary of the 529 plan to another family member who plans to attend college or graduate school. That could be yourself, your spouse, or any other child or grandchild. You can even make one of your daughter’s first cousins or another relative a beneficiary (see the Qualified Tuition Program section of IRS Publication 970 for a full list of eligible beneficiaries).
For more information about smart ways to pay for college, see our Paying for College special report.