Does a 529 Plan Affect Scholarships?

A 529 plan is a tax-advantaged savings vehicle for future educational expenses. Authorized by Section 529 of the Internal Revenue Code, these plans are typically sponsored by states or educational institutions, offering tax-free growth and withdrawals for qualified education costs. Scholarships are financial aid awards based on academic achievement, talent, or other criteria, that do not require repayment.

How 529 Plans are Considered in Financial Aid Assessments

The financial aid process, especially for federal student aid, considers a family’s financial strength for need-based assistance. This assessment relies heavily on information provided through the Free Application for Federal Student Aid (FAFSA). 529 plan assets are factored into this calculation, influencing the Student Aid Index (SAI), which replaced the Expected Family Contribution (EFC). A lower SAI generally indicates a greater financial need and potentially more aid eligibility.

For a dependent student, 529 plan assets are typically reported on the FAFSA as a parental asset. These parental assets are assessed at a maximum rate of 5.64% of their value when calculating the SAI. This means that for every $10,000 held in a parent-owned 529 plan, the SAI could increase by up to $564, potentially reducing the amount of need-based aid a student may receive. In contrast, assets directly owned by a dependent student (outside of a 529 plan) are assessed at a higher rate, often around 20%.

The ownership of the 529 plan significantly impacts its treatment on the FAFSA. If a 529 plan is owned by a grandparent or other non-parent relative, its value is not reported as an asset on the FAFSA. Such a plan does not directly affect the SAI calculation. Under the FAFSA Simplification Act (effective 2024-2025), qualified distributions from grandparent-owned 529 plans are no longer counted as untaxed income for the student on the FAFSA. This change eliminates a previous disincentive where such distributions could significantly reduce aid eligibility.

Distributions from 529 plans also receive favorable treatment for financial aid purposes. Qualified withdrawals from a parent-owned or student-owned 529 account, used for eligible educational expenses, are not considered income on the FAFSA. This ensures that using the funds for their intended purpose does not negatively impact future financial aid eligibility. While the asset value is assessed, withdrawing funds for qualified expenses does not add to the student’s or parent’s reported income for FAFSA purposes.

Interaction with Different Scholarship Types

A 529 plan interacts differently with scholarships, depending on whether they are need-based or merit-based. Need-based scholarships are awarded based on a student’s demonstrated financial need, which is directly influenced by the SAI calculated from the FAFSA.

For need-based scholarships, a parent-owned 529 plan can indirectly affect eligibility. Since the 529 plan assets contribute to the SAI, a higher SAI may reduce the amount of need-based aid a student qualifies for, including need-based scholarships. The logic is that if a family has more resources available, their calculated need for financial assistance decreases. This can mean a smaller award from institutions offering need-based scholarships.

Merit-based scholarships are awarded based on factors like academic performance, artistic talent, athletic ability, or other achievements, rather than financial circumstances. These scholarships might consider a student’s grade point average, standardized test scores, or extracurricular involvement. Because financial need is not a primary criterion for these awards, a 529 plan generally does not affect a student’s eligibility for merit-based scholarships.

For example, a student with an outstanding academic record or exceptional athletic skills could receive a merit scholarship regardless of their family’s savings in a 529 plan. The focus of these scholarships remains on the student’s accomplishments and potential contributions to the institution or program. While a 529 plan can minimally impact need-based aid, it typically poses no barrier to securing merit-based scholarships.

Options for 529 Funds When Receiving Scholarships

When a student receives a scholarship, families with a 529 plan have several options for managing their savings. This situation often arises because scholarships, even significant ones, may not cover the entirety of qualified educational expenses. Qualified educational expenses for 529 plans include tuition, mandatory fees, books, supplies, equipment, and room and board for students enrolled at least half-time.

If a scholarship covers tuition, 529 funds can be used for other qualified costs not covered by the award. These might include living expenses, such as on-campus room and board, or off-campus housing and food allowances up to the amount determined by the educational institution’s cost of attendance. Funds can also cover necessary computer equipment, internet access, and other supplies. This approach ensures the tax-free benefits of the 529 plan are maximized by applying funds to remaining eligible expenses.

Another option is to withdraw an amount from the 529 plan equal to the scholarship amount without incurring the 10% federal penalty on earnings for non-qualified withdrawals. While this withdrawal is penalty-free, the earnings portion of the distribution will still be subject to federal income tax, and potentially state income tax, because it was not used for qualified expenses. This provision allows account holders to avoid “over-saving” for college when a scholarship reduces the need for 529 funds.

Families can also change the 529 plan beneficiary to another qualified family member without tax consequences. This is useful if the original beneficiary receives substantial scholarships and has leftover funds, or decides not to pursue higher education. Qualified family members include siblings, stepparents, first cousins, and other relatives as defined by IRS regulations. Alternatively, the funds can be saved within the 529 plan for the original beneficiary’s future educational pursuits, such as graduate school or professional programs.