Students who receive a scholarship can qualify for a penalty waiver for 529 plan distributions up to the amount of the tax-free portion of the scholarship. Distributions will be subject to income tax on the earnings, however.
According to IRS Publication 970, the portion of a scholarship that is considered tax free is that which is applied to certain education costs, including tuition, books, and required supplies or equipment. The tax-free portion of a scholarship does not include room and board, travel, research, or equipment not required.
If the beneficiary of a 529 plan receives a scholarship, it may be beneficial to keep the funds in the account. Amounts remaining in a 529 plan will continue to grow tax-deferred and be available for future qualified distributions, which may avoid both a penalty and income tax on the earnings. Below are several instances where it may make more sense to keep the plan in place rather than withdraw the funds.
- If the beneficiary will need to pay for qualified education expenses, such as room and board or graduate education, in the future
- If another family member could benefit from the tax advantages of the 529 plan (According to IRS guidelines, a 529 beneficiary may be changed to a qualified family member of the beneficiary without tax consequences. Check with your state and 529 plan sponsor for any applicable rules or restrictions before making a beneficiary change.)
- If a tax-free plan-to-plan rollover to another 529 plan with a different qualified family member beneficiary is an option (Please note: If you receive a state deduction and then roll over your 529 plan into one in a different state, certain states will recapture the tax deduction you originally received for your contributions. Prior to initiating a rollover, check with the rules of your state and your plan for any potential fees.)
The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that an education-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified education expenses. The earning portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10-percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administrative/management fees and expenses.