How a Scholarship Affects Your 529 College-Savings Account

Question: We just found out that my daughter is getting a scholarship that will cover a lot of her college costs, so it looks as if we won’t need as much money from her 529 as we were expecting. Can we withdraw money from the 529 for other reasons without penalty?

Answer: That’s great news about the scholarship! You generally have to pay a 10% penalty on the earnings portion of 529 withdrawals that are not used for eligible college costs. But you can withdraw up to the amount of the scholarship without having to pay the penalty. There is no clear guidance from the IRS about the timing of the withdrawal, so Brian Boswell of Savingforcollege.com generally recommends taking the withdrawal in the year you receive the scholarship to avoid potential problems later.

You’ll still have to pay taxes on the earnings withdrawn if they aren’t used for eligible education expenses. When you withdraw money from a 529, earnings and contributions are withdrawn proportionately. See the “qualified tuition program” section of IRS Publication 970, Tax Benefits for Education, for more information.

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Your daughter may still have plenty of expenses eligible for withdrawals that are both penalty-free and tax-free. You can use 529 money tax-free for tuition, fees, required books, supplies, and room and board. As long as she’s attending college at least half-time, you can even tap the 529 tax-free for the cost of an off-campus apartment and groceries, up to the amount the college specifies as the room and board figure in its cost of attendance for federal financial aid purposes (the cost is usually listed on the college’s Web site, or ask the financial aid office). Keep receipts with your tax records. The cost of a computer, printer, related equipment and internet access also counts if used primarily by the student. See New Rules for Tax-Free Spending From Your 529 College-Savings Plan for more information.

Also, if you think your daughter might go to graduate school, you can leave the money in the account until she has to pay those bills (there’s no age limit for using 529 money). Or you can transfer the balance to another eligible family member -- her siblings, first cousins, nieces or nephews, her own children, or even her parents – who can use it tax-free for eligible college costs. See How to Transfer Money Between 529 College-Savings Accounts for more information.