What to Do When Scholarships Complicate 529 College Savings

My daughter will be graduating from college in May. Because she received a scholarship, I still have some money left in our 529 college-savings account. Can I withdraw an amount equal to the scholarship without paying taxes or a penalty?

You can withdraw money from a 529 account up to the amount of a scholarship without paying a penalty, but you’ll still have to pay income taxes on the earnings. Usually, earnings are tax- and penalty-free as long as they’re used for qualified education expenses, and contributions can always be withdrawn tax- and penalty-free. (When you take money out of a 529, earnings and contributions are withdrawn proportionately.)

So you may still be able to find ways to avoid the tax bill if you use the withdrawal for eligible education expenses. The list includes tuition, fees, required books and supplies, and room and board, whether your daughter lives in a dorm or in an off-campus apartment. (Off-campus costs can count up to the college’s allowance for room and board included in the college’s cost of attendance for financial aid purposes; you can usually find that figure on the college’s website, or you can get it from the financial aid office.) Plus, you can now use 529 money tax-free for a computer, printer, other related equipment and Internet access for a college student, too (see New Rules for Tax-Free Spending From Your 529 College-Savings Plan). There’s no age limit for using 529 money, so if your daughter ends up going to graduate school, she can use the money for those expenses.

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Another option is to switch the beneficiary of the 529 plan to another family member who plans to attend college or graduate school. That could be another child, grandchild or other eligible family member, including yourself or your spouse. See IRS Publication 970, Tax Benefits for Education for a full list.