The tax status of scholarships and how they affect withdrawals from 529 college savings plans is commonly misunderstood. The major concerns are “What will I do with my 529 plan if my child gets a scholarship? Will I have to pay taxes and penalties?”
Fortunately, there are a few special rules regarding scholarships, but they can be complicated.
What is taxable?
The first consideration is whether or not the scholarship itself is taxable. The general rule is that as long as the scholarship represents tuition or course-related expenses, it is not includable in income. If the scholarship is for room and board, represents payment for teaching, or exceeds tuition and related expense costs, it becomes taxable as income. This comes as a surprise to students who unknowingly earned a taxable scholarship and are now facing a tax bill.
How can scholarships affect 529 withdrawals?
After defining which scholarship types are taxable and which are tax-free, the next question becomes whether or not scholarships will affect 529 plan withdrawals. Normally, withdrawals from 529 plans that are used for non-education expenses are subject to taxes and penalties on growth. However, a special provision allows students who receive tax-free scholarship awards to take distributions from 529 accounts for non-educational expenses without paying a penalty. Taxes, on the other hand, are still due on the portion of the withdrawal that represents growth.
To clarify, it may help to look at an example:
Olivia is attending her freshman year of college and is living at home with her parents. She has $10,000 in tuition expenses and receives a scholarship that covers the full $10,000 of costs. Her parents own a 529 plan that was intended to help pay for Olivia’s education. As a result of the scholarship, they may elect to take a withdrawal of $10,000 from the 529 account, of which 80% is principal and 20% is growth due to market performance. In this scenario, $2,000 will be considered taxable income to Olivia’s parents. The 10% penalty is waived, thanks to the special rules surrounding scholarships.
What about education-related tax credits?
Scholarships and 529 plans also coordinate with education-related tax credits, such as the American Opportunity Credit and the Lifetime Learning Credit. If one is eligible to claim these credits, the amount of qualified education expenses that are eligible to be met by 529 plan withdrawals are reduced by these credits. While the calculation becomes more complicated, there is still an exemption for the 10% penalty accessed against 529 plan withdrawals when using educational tax credits in calculating the total amount of education expenses.
Because claiming multiple credits, receiving scholarships, and coordinating 529 plan withdrawals can be intricate, make sure to seek advice from your tax advisor and a Certified Financial Planner™ professional when setting up and taking distributions from your educational savings accounts.
Andrea L. Blackwelder, CFP®, ChFC and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with Wisdom Wealth Strategies.