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 Saving For College is, “What happens to my 529 if my child gets a scholarship?”
Unlike a student loan, a scholarship is money awarded for college that you don’t need to pay back. Scholarships can help fill the gap when a family can’t 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 lose your 529 plan if the child wins a scholarship. A 529 plan offers tax-free earnings and distributions as long as the money is used to pay for qualified education expenses. If you take a non-qualified withdrawal, you’ll incur income tax and 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.
Generally, a withdrawal from a 529 plan that doesn’t cover eligible college costs is subject to a 10% penalty from the IRS. A few notable exceptions to the 10% penalty rule include 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 says, “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 determine the scholarship’s taxable amount and calculate how much you’ll have to pay in taxes. Amounts used to pay for tuition and textbooks may be tax-free, but those used for living expenses are taxable.
3. You can change the beneficiary to another family member.
Suppose you don’t want to pay taxes when you withdraw (and why would you?) You can change the account beneficiary to another qualifying family member as the account owner. A younger sibling would be the obvious choice, but you can change the beneficiary to a parent, grandparent, niece, or nephew without tax consequences. 529 plans can now be used to pay for private elementary and high school tuition as well.
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 continue to graduate school and need help paying for it. In fact, according to the National Center for Education Statistics, the average student loan balance for those who earned a master’s degree from a private nonprofit university in 2019-20 was over $53,000. 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 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 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.
Another option is funding a Roth IRA using funds from a 529 plan. Beginning in 2024, up to $35,000 can be transferred from a 529 plan to a Roth IRA tax-free and penalty-free, subject to specific rules and restrictions.
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.
