What happens to my 529 plan if my child gets a scholarship?

Posted on August 2nd, 2013

You thought you were doing the right thing by investing in a 529 plan to save for your child’s college. But what if your student receives a scholarship that covers most, if not all, of his or her college expenses?

529 plan rules

As you may be aware, 529 plans are a tax-free way of putting money aside for college expenses, including tuition, fees, room, and board. And withdrawing funds from 529 plans early–or using the money for something other than college–can cost you. A distribution from a 529 plan that is not used for qualified educational expenses is subject to income tax and an additional 10% early-distribution penalty.

But there’s good news. If your child receives a large scholarship and you find you don’t need the funds to pay for his or her college, you have a few options.

Understand your options before withdrawing funds

One of your options is earmarking the funds for use by another family member, such as the student’s sibling or your future grandchild. You can change the beneficiary of the account anytime before that student starts college.

You can also withdraw the funds–the earnings will be subject to income tax, but luckily, the 10% federal tax penalty is waived when scholarships are present. This turns your tax-free 529 investment into a tax-deferred investment.

Before withdrawing, however, make sure you carefully evaluate your student’s college expenses. There are often unexpected costs that arise during college.

For example, study abroad programs can cost thousands of dollars above a college’s regular tuition. Attending summer classes an also add thousands to your student’s tuition bills if he she ends up having to take them in addition to a normal courseload. And books and supplies aren’t exactly cheap either.

If you find yourself with extra funds in your 529 plan and want to maximize the benefit of your savings, consider using the money to pay for an additional education expense.

The bottom line

Don’t be worried if your child receives a scholarship for college and you’ve put aside money in your 529 plan. Unfortunately, college is expensive enough that you’ll most likely going to have to use at least some of the funds.

And even if you can’t use them for educational expenses (now or in the future), you can rest easier knowing the funds won’t be subject to that additional 10% tax penalty.

Category: Financial Aid

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