Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / How 529 Plans Work With Scholarships and Merit Aid
Transcript
- Lucas: So your kid just got a $30,000 academic scholarship to a state university. Great news, right? But if you've been putting money into a 529 plan for years, that scholarship actually creates a tax puzzle that most families don't see coming. Luna: I can imagine the instinct is to just pull all the 529 money out and celebrate. But that could cost you. Lucas: Exactly. The IRS rule is specific: you can withdraw an amount equal to the scholarship penalty-free — up to the scholarship amount — but only if you do it correctly. The scholarship reduces your qualified education expenses, so if you just pull out the full tuition and also apply the scholarship, you end up with a non-qualified withdrawal and the 10 percent penalty on the earnings portion. Luna: Right, because the qualified expenses are net of scholarships. So if tuition is $40,000 and the scholarship covers $30,000, the family's out-of-pocket qualified expense is only $10,000. Lucas: That's the math. Now, the good news is that the scholarship exception allows you to take a penalty-free withdrawal up to the scholarship amount — but you still owe income tax on the earnings. It's not a tax-free withdrawal like a normal qualified distribution. The penalty is waived, but the tax isn't. Luna: So the earnings portion gets added to your income. For a family in the 22 percent bracket, that's a real hit. Lucas: It is. And here's where timing matters. The scholarship exception applies in the same tax year the scholarship is received. So if the scholarship hits in August for the fall semester, you need to take the 529 withdrawal in the same calendar year. If you wait until January, the IRS could argue the withdrawal doesn't correspond to the scholarship. Luna: That's a detail that's easy to miss. People think 'I have four years, I'll just take it out gradually.' But the exception is tied to the year of the scholarship. Lucas: Right. And there's another layer: the American Opportunity Tax Credit. That credit is worth up to $2,500 per student for the first four years, and it also relies on qualified education expenses. But you can't double-dip. You can't use the same tuition dollar to justify both a tax-free 529 withdrawal and the AOTC. Luna: So the family has to decide which dollars are 'paid' by the 529 and which are 'paid' by the credit? Lucas: Exactly. The rule is: you allocate expenses. If tuition is $40,000 and the scholarship covers $30,000, you have $10,000 of out-of-pocket qualified expenses. You could use that $10,000 to justify a tax-free 529 withdrawal, or you could claim the AOTC using that $10,000 — but not both. Usually, the AOTC is more valuable because it's a dollar for dollar credit, so many families use the out-of-pocket expenses for the credit and then take the scholarship exception withdrawal from the 529 for the $30,000. Luna: That makes sense. But then that $30,000 withdrawal still has taxable earnings. So the strategy is to minimize the earnings portion by withdrawing from contributions first? Lucas: The IRS doesn't let you cherry-pick. Every 529 withdrawal is pro-rata between contributions and earnings. So if your 529 account is 70 percent contributions and 30 percent earnings, every dollar you withdraw is 70 cents of contribution and 30 cents of earnings. You can't pull only contributions. Luna: Right, I've seen that trip people up. They think they can just take their own money back first. Lucas: A common workaround is to pay the first semester's tuition directly from the 529 — that's a qualified expense, no tax, no penalty. Then, for the next semester, you can apply the scholarship and take a penalty-free withdrawal for the same amount. But you'd still owe tax on earnings. Luna: What about the scenario where the scholarship covers room and board? Room and board is a qualified expense even if paid with a scholarship, right? Lucas: It is, but only up to the college's published cost of attendance. So if the scholarship specifically covers room and board, that amount is still treated as a scholarship and reduces your qualified expenses. But if the family has to pay room and board separately with 529 funds, that's fine — it's a qualified expense. Luna: One thing that's always bugged me: what if the student gets a full-ride scholarship? Tuition, fees, room, board — everything. Then there are zero qualified expenses. Can you still pull money out without penalty? Lucas: You can, but only up to the scholarship amount, and it's still taxable on earnings. And you can't just withdraw the entire 529 if the scholarship is only for four years. The exception is per year. If the student gets a full ride for all four years, you could potentially withdraw the full account over those four years, paying tax on earnings each year. But any withdrawal beyond the scholarship amount — or after the scholarship ends — would be subject to the 10 percent penalty on earnings. Luna: So the planning really starts before the scholarship even arrives. Ideally, you don't overfund the 529 if the kid is likely to get merit aid. Lucas: That's the smartest takeaway. If you have a high-achieving student, you might want to be more conservative with 529 contributions. You can always use a Roth IRA or a taxable account for flexibility. And remember, since the SECURE 2.0 Act, you can roll over up to $35,000 from a 529 to a Roth IRA for the beneficiary — but that's a topic we covered in Episode 10. Luna: Right, that's a great safety valve. But for families already sitting on a large 529 balance and a scholarship, what's the best move? Lucas: Two things. First, coordinate with the AOTC to maximize the credit. Second, consider using the scholarship exception each year for the penalty-free but taxable withdrawal. If the earnings are manageable, it's fine. Or, if the account is very large, you could change the beneficiary to a sibling who might not get a scholarship. Or even to a grandchild. Luna: And if none of that works, you could just leave the money in the account and use it for graduate school. Many scholarships only cover undergrad. Lucas: Exactly. Graduate school qualified expenses are the same — tuition, fees, books, equipment, and up to the cost of attendance for room and board. So the 529 can just sit and grow tax-deferred for another few years. Luna: That's a nice option. But I want to come back to the pro-rata rule for a second. Say the 529 has $50,000, with $20,000 in earnings. The student gets a $10,000 scholarship. If the family takes a $10,000 withdrawal, $4,000 of it is earnings — taxable at ordinary rates. Is there any way to avoid that tax? Lucas: Only if the family can show that the withdrawal was used for other qualified expenses that weren't covered by the scholarship. For example, if the scholarship only covers tuition but the family uses the 529 to pay for a laptop and a dorm room, those are qualified expenses. But if the scholarship already covers everything, then the exception is the only path. Luna: So documentation is key. Families should keep the scholarship letter, the 529 withdrawal receipt, and the tuition bill all in one file. Lucas: Absolutely. And one more thing: if the student later loses the scholarship — say they fail to maintain a GPA requirement — the 529 withdrawal that was previously penalty-free under the scholarship exception becomes retroactively non-qualified. The IRS expects you to amend your return and pay the penalty. Luna: Wow, that's harsh. So the penalty waiver is conditional on the scholarship being actually received and kept. Lucas: Exactly right. So it's a good idea to not withdraw the full scholarship amount until after the add-drop period when the scholarship is locked in. Luna: That's practical advice. You know, conversations like this — where we dig into the actual mechanics of a tax rule — are exactly what makes this show valuable to me. And I think our listeners feel the same way. It's why we keep the show free and ad-free — no sponsors interrupting, no product placements. Lucas: That's intentional. We want the content to be the only thing you hear. So if you find these episodes useful, and you want to support that ad-free choice, there's a simple way: you can go to buy me a coffee dot com slash fexingo. That's the only ask we make. It helps cover the production time and keeps us independent. Luna: And it really does make a difference. Even a small contribution helps us keep the lights on. Lucas: Alright, back to scholarships. There's one more nuance I want to highlight: the timing of the 1099-Q. The 529 plan will issue a 1099-Q showing the gross distribution and the earnings. You report that on your tax return, and then you show the scholarship exception on Form 5329 to avoid the penalty. It's straightforward, but it's an extra form. Luna: So it's not something you can just ignore if you use TurboTax. You need to manually enter the exception. Lucas: Right. And if you also claim the AOTC, you'll need to ensure the numbers add up. I've seen audits where the IRS compared the 1098-T tuition statement, the 1099-Q, and the AOTC claim. If they don't reconcile, you get a letter. Luna: So the takeaway is: plan ahead, coordinate credits, keep good records, and if you have a scholarship winner, don't let the 529 money sit idle without a strategy. Lucas: Exactly. And if you're unsure, a CPA who works with education planning is worth the fee. The tax savings from proper coordination can easily cover the consultation.