The truth about scholarships and 529 plans

Despite their numerous benefits, many parents hesitate to enroll in a 529 plan because they’re not sure what the future holds for their child. One of the most common questions we hear at Savingforcollege.com is “What happens to my 529 if my child gets a scholarship?”

A scholarship, unlike a student loan, is money awarded for college that doesn’t need to be paid back. Scholarships can help fill the gap when a family isn’t able to save for their entire college bill, and they can put a coveted, more expensive school within reach. But just because you feel your child has a good shot at winning a scholarship one day doesn’t mean you should hold off on saving with a 529. Here’s why:

1. You don’t lose all or even most of your savings. 

It’s a myth that you’ll lost your 529 plan if the child wins a scholarship. A 529 plan offers tax-free earnings and tax-free withdrawals as long as the money is used to pay for qualified education expenses. If you end up taking a non-qualified withdrawal, you’ll incur income tax as well as a 10% penalty – but only on the earnings portion of the withdrawal. Since your contributions were made with after-tax money, they will never be taxed or penalized. You can always use the leftover money for graduate school, continuing education or a future grandchild’s education.

2. You can avoid the penalty if you get a college scholarship. 

There are a few special exceptions to the 10% penalty rule, including when the beneficiary becomes incapacitated, attends a U.S. Military Academy or gets a scholarship. In the case of a scholarship, non-qualified withdrawals up to the amount of the tax-free scholarship can be taken out penalty-free, but you’ll have to pay income tax on the earnings. As Savingforcollege.com founder Joe Hurley likes to say, “the scholarships have turned your tax-free 529 investment into a tax-deferred 529 investment”.

Did you know that scholarships are taxable? 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. Amounts used to pay for tuition and textbooks may be tax-free, but amounts used to pay for living expenses are taxable.

3. You can change the beneficiary to another family member. 

If you don’t want to pay any taxes when you withdraw (and why would you?), you also have the option of changing the account beneficiary to another qualifying family member. A younger sibling would be the obvious choice, but you can also change the beneficiary to a parent, grandparent, niece or nephew without tax consequences. Beginning January 1, 2018, 529 plans can also be used to pay for tuition at private elementary and high schools.

4. You can hold on to your savings. 

Unlike other college savings vehicles, such as Coverdell Education Savings Accounts, there’s no time limit on 529 savings plans – which means you can let your savings grow in your account until you have a use for them. Your child who earned a scholarship may very well continue on to graduate school and might need some help paying for it. In fact, according to the New America Foundation, the median combined student loan balance for those who earned a graduate degree in 2012 was $57,600. Every penny paid for with the 529 account will reduce your child’s potential debt burden.

Another option is to use your savings to continue your own education. 529 plans can be used to pay for courses at any eligible institution, including community colleges and vocational schools. Whether you’re looking for a career change or taking up a new hobby, simply make yourself the beneficiary of the 529 plan and you’ll be able to start taking tax-free withdrawals to pay for your courses.

5. You can use a 529 plan to pay for more than just college tuition. 

For example, let’s say your child wins a full-tuition scholarship that pays for tuition and fees to attend Duke University. In this case you might still be able to take a tax-free withdrawal from your 529 plan, since qualified higher education expenses under Internal Revenue Code Section 529 include books, required supplies and equipment and some room and board. For students attending Duke this year, these costs totaled just over $18,000.