Answers to Questions about Distributions from a 529 Plan

During our webinar about How to Reach Your College Savings Goals with a 529 Plan, participants asked dozens of questions. Here are the answers to questions about distributions from a 529 plan.

How Scholarships Affect 529 Plan Distributions

What happens if my child receives a full-ride scholarship to college?

The earnings portion of a non-qualified distribution from a 529 plan is normally subject to income tax and a 10% tax penalty, plus possible recapture of state income tax breaks attributable to the distribution.

However, if the distribution is taxable because the beneficiary’s qualified higher education expenses were reduced because of the receipt of tax-free scholarships or grants, the 10% tax penalty will be waived up to the amount of the scholarships and grants. The non-qualified distribution is still subject to income tax and recapture of state income tax breaks. 

A similar penalty waiver applies to the receipt of other tax-free educational assistance, such as Veterans’ educational assistance, employer-paid educational assistance, attendance at a U.S. military academy, and education tax benefits such as the American Opportunity Tax Credit (AOTC) and Lifetime Learning Tax Credit (LLTC).

The tax penalty is also waived due to the death or disability of the beneficiary. 

Did you know scholarships can be taxed? Use our Scholarship Tax Calculator to figure out the taxable amount of your scholarships and calculate how much you’ll have to pay in taxes.

How do you prove the scholarship amount to be able to withdraw the money from the 529 plan to not have to pay the 10% penalty? Do you have to withdraw the total scholarship dollars?

You will need to report the taxable portion of the non-qualified distribution as income on your federal income tax return and the 10% tax penalty on Schedule 2. 

You should keep documentation relating to the scholarship in case your federal income tax returns are audited. Documentation may include a copy of the scholarship award letter, a copy of the scholarship check and a copy of IRS Form 1098-T issued by the college. 

You do not need to withdraw the full amount of the scholarship from your 529 plan. You can withdraw less. But, you cannot withdraw the remainder penalty-free in a subsequent year, since distributions must be made in the same tax year as the scholarship was used to pay for qualified higher education expenses. 

If kids get a full scholarship, can a 529 plan be changed to an annuity for the parents? Will there be fees?

A 529 plan cannot be changed to an annuity. However, if you take a non-qualified distribution from a 529 plan, that money can be invested in an annuity, if you wish. The 10% tax penalty on the non-qualified distribution will be waived up to the amount of the scholarship, but the earnings portion of the non-qualified distribution will still be taxed as income.

If the 529 plan is a custodial 529 plan, distributions from the 529 plan must be used for the benefit of the beneficiary, not the parents. So, a non-qualified distribution can be invested in an annuity for the student, not the parents. 

Timing of 529 Plan Distributions and Qualified Expenses

How do you sync up a payment for January 1st rent for student? If the rent is due on January 1, then the 529 would need to mail the check prior to the new year, thus a withdrawal for future year in current year?

Qualified distributions must be made in the same year as the qualified higher education expense is paid, not the year the qualified higher education expense is due. 

For example, if tuition for the spring term is due in January, you can take a distribution to pay the tuition bill in December if you pay the tuition bill in December. On the other hand, if you will be paying the tuition bill in January, you must wait until January to take the distribution from the 529 plan. 

Thus, the timing of the distribution must match the timing of the payment. 

Can you prepay for a loan with the 529 early before graduating?

529 plans can be used to repay up to $10,000 in the beneficiary’s student loans. A 529 plan can also be used to repay up to $10,000 each for each of the beneficiary’s siblings. The $10,000 limits are lifetime limits per borrower.

There is no requirement for the loans to be in a repayment status. You can pay off the debt before the student graduates.

For example, distributions from a grandparent-owned 529 plan before January 1 of the sophomore year in college will count as untaxed income to the student on the Free Application for Federal Student Aid (FAFSA). One strategy is to borrow a student loan to pay for college costs during the first year and a half, and then use 529 plan money to repay the loans when the distributions no longer affect eligibility for need-based financial aid. 

If withdrawing for a non-qualified expense, do FIFO or FILO rules apply?

No. The earnings portion of a distribution is assumed to be proportional to the total earnings in the 529 plan. You do not get to choose which portfolios are sold to provide funds for the distribution. 

Impact of Free Tuition on 529 Plans

What would happen to our 529 college savings plan if in sometime from now to the future, college tuition were to become free?

529 college savings plans can be used to pay for many other college costs besides tuition and fees. Qualified higher education expenses also include 

• Books, supplies and equipment
• Computers, peripherals, software and Internet access
• Room and board (if enrolled at least half time)
• Special needs expenses
• Student loan repayment

Tuition and fees are only about half of college costs at 4-year public colleges and about two-third of college costs at 4-year private non-profit colleges. 

The account owner can also choose to take a non-qualified distribution if there is leftover money or leave the money in the 529 plan. 

Using a 529 Plan to Pay for High School

My Godchild just was accepted into a Catholic high school for their sophomore year. I can use a 529 for high school, right?

Yes. 529 plans may be used to pay for up to $10,000 per year in tuition at elementary and secondary schools. Some states consider using a 529 plan to pay for K-12 tuition to be a non-qualified distribution and will recapture state tax breaks attributable to the distribution. It might be best to have separate 529 plans for high school and college, so that you don’t use money intended to pay for college to pay for high school. Also, the investment horizons are shorter when saving for elementary and secondary school than for college. 

Using a 529 Plan to Repay Parent Student Loan Debt

Can 529 plan funds only be used for your child education expenses or can it also be used for your own student loan debt?

Distributions from a 529 plan are considered to be qualified when they are used to pay the qualified educational expenses of the beneficiary.

Distributions to repay student loan debt are considered to be qualified when they are used to repay the student loans of the beneficiary and the student loans of the beneficiary’s siblings. There is a $10,000 lifetime limit per borrower for qualified distributions to repay student loan debt.

The account owner of a 529 plan can change the beneficiary to be themselves and then take a qualified distribution to repay their own student loans. 

Although using a 529 plan to repay student loans is considered a qualified expense by the federal government, some states consider student loans to be a non-qualified expense. This could lead to state income tax but not federal income tax on the earnings portion of the student loan payment. 

Options for Unused 529 Plan Funds

What happen to the money in a 529 college savings plan, if later it will not be used?

Money can stay in a 529 plan forever. 

There are several options for using the leftover money in a 529 plan.

• Change the beneficiary to a sibling or the parent, to use for their education
• Take a distribution to pay for up to $10,000 in student loans per borrower for the beneficiary, the beneficiary’s siblings or, with a change in beneficiary, the parent or another family member 
• Use the 529 plan to pay for graduate school or continuing education
• Save the money for the beneficiary’s children
• Take a non-qualified distribution