What to Do with 529 Money If Your Child Gets a Scholarship

Ok, imagine this (or maybe I should say "dream of this"): you save for years in a 529 college savings plan so that your child can have a great college education paid for by you (we'll ignore the "who should pay for college?" issue on this post) and then that little stinker goes and does the unthinkable -- he gets a scholarship. (Imagine the horror!!!!) Now he's not going to need the money you've saved. But can you get it back? And how? And under what circumstances?

Kiplinger answers these questions for us in Scholarships and 529 Plans, starting with the following:

If one of your children is fortunate enough to win a scholarship, you'd be eligible to take a penalty-free withdrawal from her 529 account up to the amount of the award. You would, however, have to pay federal and state income tax on the earnings portion of the withdrawal. To avoid those taxes, you could name another family member as beneficiary of the plan.

That's a start. But there's another option. Just because Junior gets a big scholarship doesn't mean there will be no college expenses for him. Consider this:

Even if your child gets a full-tuition scholarship, you'll probably still have plenty of other bills that qualify for tax-free withdrawals from her 529 plan -- including required fees, books, supplies and equipment. As long as your daughter attends school at least half-time, room and board count, too. And if she lives off campus, you can take a qualified withdrawal up to the cost of on-campus housing at that institution.

So the "good news" is that even if your son gets a great scholarship, there are more than enough expenses to go around. :-)

And finally, if you can't use the funds on your kids, you can transfer the money and use it yourself:

In the unlikely event that any money remained after all your children were educated, you could let them use it for grad school, use it yourself, transfer it to another family member, or take it back and pay income taxes on the earnings plus a 10% penalty.

Ok, so here are your options in order as I see them:

1. Pay for expenses that aren't covered by the scholarship.
2. Transfer the funds to another child and pay for her college expenses.
3. Use it yourself.
4. Take a penalty-free withdrawal from the account for the amount up to the award.
5. If you still have money left over, take it back and pay income taxes on the earnings plus a 10% penalty.

Did I miss anything?

Comments

[broknowrchlatr]

You missed one thing. Say you are down to option #5. You are going to take a 10% penalty and pay taxes anyway, so why not keep the account open till you retire? You will get to have it grow interest free indefinately, then pay taxes on it and the 10% penalty that you would have to pay anyway.

Unless you have options 1-4, I think this is a great option. This especially applies if the total ammount is mroe than college costs. If the market goes up a lot and the 529 is worth $100k and 4 years of school is $80k, keep the rest till retirement.

[jtg]

Can't you also reserve it for graduate school? That might be an option if the student is considering a career that involves some sort of graduate or professional degree.

[andy]

I heard on the radio the other day that you can actually use the money saved in your 401K account and use that fund as a college education fund. Any thoughts or comments on this?

[Super Saver]

FMF,

This is a problem I hope I will have when my daughter goes to college :-)

[Margo]

Could you keep it in your kid's name, and then transfer it to the grandkid's name (when born)? I've thought about this being a good strategy to pass some money down the generations tax-free, but I haven't yet investigated all the nuances of it.

I fully expect I'll need the $6500 in my 529 for an MBA program. There aren't too many full-ride plus expense scholarships for b-school!

[Pam]

My daughter did receive a full ride scholarship and I have a 529 plan for her. (books are the only expense we pay for) Should I take out the amount from her 529 each year for that years scholarship portion and invest elsewhere for her? I wanted her to be able to use this for a house after college. She might continue with more college after her 4 year scholarship but I don't expect more than 1 year.
I feel the penalty for taking it out because of her scholarship is a bit crazy but that's our government.
Would appreciate your advise on this.
Thanks!

[Luis]

I agree with the government in this instance. The scholarship did not cause the excess investment in the 529, you overinvested it regardless of scholarship. The 10% penalty eliminates the tax loophole. That's not crazy.
Take out the tax free withdrawal portion and gift the maximum amounts to your daughter to put in some liquid accounts (CD's, money market, etc.)

[FMF]

Pam --

I'll post your question as a "Help a Reader" post sometime in October. Stay tuned to the site to see what the readers advise.