What Happens to a 529 if Your Child Gets a Scholarship?

A 529 plan is a tax-advantaged savings account designed to cover future education costs. When a child earns a scholarship, it is a significant accomplishment that can alleviate some of the financial burden of higher education. This positive development, however, often raises questions for families who have diligently saved in a 529 plan. Fortunately, the funds are not lost, and several flexible options are available to the account owner.

The Scholarship Withdrawal Exception

Federal tax law provides an exception that allows an account owner to withdraw funds up to the amount of a tax-free scholarship without incurring the usual 10% penalty on earnings. This rule is designed to prevent families from being penalized for their child’s academic or athletic success. While the exception waives the penalty, ordinary income tax is still due on the earnings portion of the withdrawal. You must keep clear records of the scholarship award for your tax filings.

For example, if your child receives a $10,000 scholarship and your 529 plan has a total value of $50,000, with $40,000 in contributions and $10,000 in earnings, you could withdraw $10,000. In this scenario, since 20% of the account is earnings, 20% of your $10,000 withdrawal, or $2,000, would be considered earnings. This $2,000 would be subject to your ordinary income tax rate, but you would avoid the standard 10% penalty.

This withdrawal must be made in the same calendar year the scholarship is awarded to qualify for the penalty waiver. The definition of a “tax-free scholarship” is broad and includes awards for academics, arts, and athletics, as well as other forms of tax-free educational assistance like grants.

Using Funds for Other Qualified Expenses

Even with a full-tuition scholarship, a 529 plan can cover other Qualified Higher Education Expenses (QHEEs) tax-free. These funds can be used for required books, supplies, and equipment for courses, including textbooks and any other materials mandated for enrollment. The plan can also pay for technology expenses, such as computers, software, and internet access, provided they are used primarily by the beneficiary while enrolled.

Room and board costs are another expense that can be paid from a 529 plan, as long as the student is enrolled at least half-time. For students living off-campus, the amount that can be withdrawn for housing is limited to the allowance for room and board included in the college’s official cost of attendance figures.

Recent changes have also expanded the use of 529 funds. Account owners can make tax-free withdrawals to pay for fees and supplies associated with a registered apprenticeship program. Up to a lifetime limit of $10,000 per individual can also be used to repay qualified student loans for either the beneficiary or their siblings.

Reassigning the 529 Plan Funds

If the funds are not needed for undergraduate costs, you can change the beneficiary to another eligible family member without tax consequences. This can be a sibling, first cousin, parent, or even the account owner if they plan to pursue further education. The process involves completing a form with the 529 plan provider and providing the new beneficiary’s identifying information, such as their Social Security Number.

The funds can also be left in the account for the original beneficiary’s future educational needs. Many students pursue graduate or professional degrees, and the 529 plan can remain invested and grow tax-deferred until those expenses arise. There are no age or time limits on when the funds must be used, providing long-term flexibility.

A newer option, introduced by the SECURE 2.0 Act, allows for a tax-free rollover from a 529 plan to a Roth IRA for the beneficiary. This is subject to strict rules: the 529 account must have been open for at least 15 years, and contributions rolled over must have been in the account for more than five years. The amount rolled over is subject to the beneficiary’s annual Roth IRA contribution limit and a lifetime maximum of $35,000.

Making a Non-Qualified Withdrawal

If no other option is suitable, the account owner can withdraw the funds for a non-qualified purpose. This is the least tax-efficient choice and should be considered a last resort. When taking a non-qualified distribution, the portion of the withdrawal that comes from your original contributions is returned tax-free and penalty-free.

The earnings portion of the withdrawal, however, will be subject to both ordinary income tax at the recipient’s rate and a 10% federal tax penalty. Some states may also impose their own penalties or require the recapture of previously claimed state tax deductions. The plan administrator will provide an IRS Form 1099-Q that details the gross distribution and the taxable earnings portion.