Use a 529 Plan When Your Child Wins a Scholarship

Question:

My daughter received a full volleyball scholarship to college, so we’re wondering what to do with her 529 college-savings plan. Can we withdraw the amount of the scholarship without penalty?

Answer: You can withdraw up to the amount of the scholarship without having to pay the 10% penalty, but you will have to pay taxes on the earnings. (A portion of each withdrawal is considered to be from principal, and a portion comes from earnings.)

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But before you make a scholarship withdrawal, it’s a good idea to see if you can use the money tax-free for other eligible college expenses.

Besides tuition, you can use the 529 money tax-free for room and board. If your daughter lives on campus, the 529 money can cover the full cost of room and board paid to the college. Even if she lives off campus, she can spend the 529 dollars tax-free for her housing costs, up to the school’s allowance for room and board. (You can find the allowance amount on the school’s website under the cost of attendance or by contacting the financial aid office.) Off-campus room and board only counts if the student is enrolled at least half-time.

You can also withdraw the money tax-free for textbooks, fees, and required supplies and equipment. “Essentially, you can use the money for any expense that is required by the school,” says Kaellen Hessel, of the Oregon 529 Savings Network. “For example, if you are going to art school, then art supplies would be an allowed expense.” The money can also be used to buy a computer and software for your daughter, if she will need it for her schoolwork.

There’s no time or age limit for using the money. So even if your daughter doesn’t spend the money while she’s an undergraduate, she could use it later for graduate school. Or you could change the beneficiary to another eligible family member headed to college, including your daughter’s siblings, nieces, nephews, parents, aunts, uncles, spouse or in-laws. You could even keep the money in her name and ultimately transfer the beneficiary to her own children later. Your daughter could then use up to $10,000 per beneficiary each year to pay for tuition for kindergarten through 12th grade. Or, she can save the money until her kids need it for college.

See the “Qualified Tuition Program” section of IRS Publication 970, Tax Benefits for Education , for more information about the rules.

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As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.