Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / Scholarship Impact on 529 Plan Withdrawals
Transcript
- Lucas: So we've spent a lot of episodes talking about what counts as a qualified education expense for a 529 plan. Tuition, room and board, computers, even off-campus parking. But here's the question that always comes up in planning conversations: what happens if your kid gets a scholarship? Luna: Right, because the whole point of a 529 is tax-free growth and withdrawals for education. But if the scholarship covers tuition, suddenly you've got money sitting in the account that you might not need for that purpose. Lucas: Exactly. And the IRS actually has a specific rule for this. It's called the scholarship exception. If your child receives a tax-free scholarship, you can withdraw an equal amount from the 529 plan without paying the 10% penalty on earnings. Luna: But you still owe income tax on the earnings portion, right? Lucas: That's the crucial part. The 10% penalty is waived, but you still pay ordinary income tax on the earnings that come out. So it's not a free pass. The tax-free benefit of the 529 only applies to qualified expenses. A scholarship doesn't make the withdrawal qualified; it just exempts the penalty. Luna: So if you withdraw $10,000 because your child got a $10,000 scholarship, and $2,000 of that was earnings, you'd pay tax on that $2,000 but no penalty. Lucas: Correct. And this applies only to tax-free scholarships — the kind that pay for tuition and fees directly. If your child gets a scholarship that covers room and board, that's different because room and board is already a qualified expense. So you wouldn't even need the exception. Luna: Good point. So the exception really matters when the scholarship covers tuition, which is the biggest chunk of college costs. But what about partial scholarships? Say the scholarship covers half of tuition. Lucas: Then you can withdraw up to the amount of that scholarship penalty-free. The rest of the 529 money can still be used for other qualified expenses like room and board, books, or a laptop. And if you still have leftover funds, you have options. Luna: Like changing the beneficiary to another child, or even yourself for continuing education. Lucas: Absolutely. You can change the beneficiary to a qualifying family member — sibling, parent, even first cousin. Or you can keep the money for graduate school. Remember, the beneficiary doesn't have to be your child. And if the scholarship fully covers graduate school too, you might not need the 529 at all. Luna: But what if you really want to use the money now, and the scholarship is only for one year? Can you withdraw for that year penalty-free? Lucas: Yes, you can. The exception applies each year you have a scholarship. You can withdraw the scholarship amount for that academic year. But you need to be careful about timing. The withdrawal should be in the same year the scholarship is received to avoid complications. Luna: And what about scholarships that aren't just for tuition? Like a full-ride scholarship that also includes a stipend for living expenses? Lucas: If the stipend is taxable, then that portion isn't considered a tax-free scholarship. So you'd need to use the 529 for qualified expenses like room and board, or pay tax and penalty on non-qualified withdrawals. It gets nuanced. Luna: So the key is matching the withdrawal to the type of scholarship. Let's talk about athletics scholarships — those often cover tuition and fees. Same rule applies? Lucas: Same rule. Any tax-free scholarship, whether academic, athletic, or merit-based, qualifies for the penalty exception. But you have to document it. Keep the scholarship letter, the 1098-T form from the college, and your withdrawal records. Luna: And what if the scholarship is revoked or the student changes schools? Does the withdrawal become retroactively non-qualified? Lucas: That's a tricky scenario. If you rely on the scholarship exception and the scholarship disappears, you might have to treat the withdrawal as non-qualified. You'd owe tax and penalty on the earnings. So it's safer to only withdraw after the scholarship is confirmed and not conditional. Luna: Yeah. So planning ahead matters. Let's talk about the bigger picture: what if your child gets a full scholarship and you have a large 529 balance? You could change the beneficiary, but what if you don't have another child? Lucas: Then you have a few choices. You can leave the money in the account for future grandchildren, or you can withdraw the amount equal to the scholarship penalty-free but pay tax on earnings. Or you could take a non-qualified withdrawal and pay both tax and penalty. The last option is usually the worst. Luna: There's also the option to roll over 529 funds into a Roth IRA for the beneficiary, but that's limited to $35,000 total and requires the account to be open for 15 years. That might not apply to a scholarship situation unless you've been saving for a long time. Lucas: Right, and we did a whole episode on that. But for a scholarship scenario, the Roth rollover might be a good fit if the beneficiary doesn't need the money for education. But the 15-year rule is a hurdle if the account is newer. Luna: So what's the one mistake families make most often with scholarships and 529s? Lucas: I think it's assuming that the scholarship automatically makes the withdrawal penalty-free and tax-free. They forget that earnings are still taxed. Or they withdraw more than the scholarship amount and trigger penalties on the excess. The IRS doesn't give you a grace period if you miscalculate. Luna: And you can't double-dip — you can't use the scholarship to pay for tuition and then also withdraw 529 funds for the same tuition. That would be a non-qualified withdrawal. Lucas: Exactly. The rules require coordination. Ideally, you pay tuition with the scholarship, then use the 529 for other qualified expenses like room and board, books, and fees. That way you avoid any penalty and keep the tax-free treatment. Luna: Let's walk through an example. Suppose your child has a $20,000 scholarship for tuition. Tuition is $20,000. They also have $12,000 in room and board and $1,000 in books. The 529 has $30,000 in it. How should they use the 529? Lucas: Simple — use the 529 for the $12,000 room and board and $1,000 books, all qualified. Then you can withdraw up to $20,000 under the scholarship exception, but you'll pay tax on the earnings. If the 529 earnings are, say, 30% of the withdrawal, you'd owe tax on $6,000. Much better than a non-qualified withdrawal where you'd also pay a 10% penalty on the earnings. Luna: That makes sense. But what if the student lives at home and has no room and board costs? Then the only qualified expense might be tuition, which is covered by the scholarship. So you're forced to use the scholarship exception for any withdrawal. Lucas: Right, or you could leave the money in the account for future education. The flexibility is there, but it requires planning. Luna: And this is the kind of detail that a lot of families don't realize until they're filling out the withdrawal form and suddenly see a tax bill. Lucas: Yeah, it's exactly the kind of thing we try to break down here. And if today's episode helped you think about your own 529 plan more clearly, listener support is what keeps this show ad-free. You can find us at buy me a coffee dot com slash fexingo. Luna: That really helps us keep going. Alright, so back to the scholarship exception — there's also a nuance with the timing of the withdrawal relative to the scholarship award. Lucas: Yes. The IRS says the withdrawal must be in the same tax year as the scholarship is received. So if your child gets a scholarship in 2026 but you withdraw in 2027, you may not qualify for the penalty exception. That's a common trap. Luna: So you need to plan the withdrawal to coincide with the scholarship year. If the scholarship is for the 2026-2027 academic year, you should withdraw in 2026 for the fall semester and 2027 for the spring? Or can you do it all in one year? Lucas: The rule is that the scholarship must be received in the same year. But if the scholarship is awarded for a specific academic year, you can usually withdraw in the calendar year that includes that academic period. Many families just do one withdrawal in the spring of the following year, but that might not align. Better to do it in the same calendar year the scholarship is used. Luna: Let's also touch on employer-provided tuition assistance. That's technically a scholarship in some cases — if it's tax-free. Would that trigger the exception? Lucas: If it's a qualified tuition reduction and tax-free, yes. But many employer programs are taxable as income, in which case they wouldn't count. You'd need to check with HR. The key is whether the scholarship is excluded from income under the tax code. Luna: And what about military tuition assistance? That's usually tax-free. Lucas: Yes, that qualifies. Same rules apply. Luna: So to wrap up, the scholarship exception is a valuable tool, but it's not a loophole. You still pay tax on earnings. The real value of a 529 is when you can use it for qualified expenses tax-free. Scholarships change the equation, but with careful planning you can avoid penalties. Lucas: Exactly. And the best approach is to coordinate with your tax advisor, keep good records, and think ahead about how you'll use the money. If you plan to use the scholarship exception, make sure the withdrawal matches the scholarship amount and year. Otherwise you might end up with a nasty surprise at tax time. Luna: Good advice. Thanks Lucas. Lucas: Thanks Luna. That's it for today's College Savings Podcast. We'll be back with more tips on navigating the world of education funding.