As a followup to my recent post on common misconceptions about 529 plans, I just wanted to highlight an additional way to get unspent money out of the account without paying taxes or penalties. A sharp-eyed reader named Courtney asked:
Iâ€™ve heard that if your child obtains a scholarship, you can withdraw that amount from the 529 plan without paying the 10% penalty. Is that true?
The last thing that you want is to save diligently for your child’s education, only to be penalized when they receive a scholarship and don’t need all of the money that you’ve socked away. So… What’s the deal with scholarship and 529 plans?
As it turns out, the typical 10% penalty on non-qualified distributions is waived when withdrawals can be attributed to a scholarship that the beneficiary has received. More specifically, section 530(d)(4) of the Internal Revenue Code states that this penalty exception applies to distributions made “on account of” a scholarship.
What’s less clear is when you have to take the distribution to qualify for penalty-free status. Do you need to take the withdrawal during the year in which the scholarship was awarded, or can you wait until later? The IRS hasn’t provided any clear guidance on this question.
While you you won’t have to pay the penalty for a scholarship-related withdrawals, however, you will have to pay income tax on the earnings portion of your withdrawal. Of course, even if your kid gets a major scholarship, they may have enough other education-related expenses to draw down your 529 savings plan.