June 13, 2019
Great news: Your graduating high school senior has received a merit-based scholarship that will pay for much—maybe even all—of their higher education.
But what does it mean for your college savings?
For years, you made regular contributions to your 529 college savings account, and the account now has a balance that your child no longer needs. That presents a dilemma. If you withdraw funds, the earnings portion of the withdrawal that you don’t use for qualified higher education expenses is subject to federal and likely state taxes and a 10 percent federal tax penalty.
What should you do?
Fortunately, there are options that can help you avoid or minimize the tax consequences of making a nonqualified withdrawal of funds from your account.
Use your account to plug the gaps. Most academic scholarships do not pay for every qualified expense your child will incur. Use your 529 account funds to cover any tuition and fee deficits.
You can also withdraw funds to buy books, computers, software and related equipment, or pay for internet access. Room and board expenses are qualified higher education expenses, as long as the student is enrolled at least half time and don’t exceed the cost of attendance as determined by the eligible educational institution, or, if greater, the invoice amount a student living in on-campus housing is charged for room and board. Withdrawals need to be made within the same time period as the expense.
Delay withdrawals. Save any unused account funds in case your child decides to pursue a graduate degree, including law school or medical school. Your 529 account can be used to pay those expenses.
Change your account beneficiary. Instead of closing your account by making a nonqualified withdrawal of your funds, you can change the account beneficiary, as long as the new beneficiary is a member of the family of the previous beneficiary. Family members include, among others, a brother, sister, parent and first cousin.
If you must make a nonqualified withdrawal, limit the size. Internal Revenue Service rules allow account owners to make a nonqualified withdrawal of funds up to the amount of the scholarship without being required to pay a 10 percent federal tax penalty on the portion of the withdrawal that is earnings. The earnings portion will still be subject to federal and likely state income taxes.
Please consult a tax advisor first before proceeding if you have questions about your particular situation. Also, find out specific regulations from your state’s 529 plan.