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How a Scholarship Affects Your 529

These three tips can help you maximize the tax benefits of 529 accounts.

Q: If you save money in a 529 and then your child gets a scholarship, what is the best course of action?

A: If you're in the enviable position of having diligently saved for your child's college education and he or she earns a scholarship, you can withdraw the money in the amount of the scholarship and the 10% nonqualified withdrawal penalty is waived on that amount. This might not be the best course of action because you will pay ordinary income tax on the earnings portion of your 529 balance. (The contributions were made with aftertax dollars, remember, so the amount over the contribution amount represents earned income that has not yet been taxed.)

One of the biggest benefits of saving in a 529 account is that your earnings are tax-free if used for qualifying expenses. If you don't want to pay the taxes on the earnings portion (and really, who does?) here are a few ideas.

1. Use the money for other qualified expenses. You can use the remaining funds in the 529 for room and board, books, computer equipment, and other qualified school supplies. (Remember that in most cases, even a "full ride" scholarship doesn't include room and board; if scholarship money is used to pay for room and board, that amount is considered taxable income.) In many cases, room and board costs are considered qualified 529 expenses, though, which means you won't pay taxes on a withdrawal taken to fund them. (If you're not sure if an expense is qualified or not, this Question and Answer article on the IRS website may help. The school's financial aid office may also be able to provide answers.)

2. Use the money for grad school or for a family member. If part of your college costs is offset by a scholarship and you anticipate that you will have more qualified college expenses in the future, your best course could be to leave the funds in the 529 and not withdraw them. That way, you're allowing the money in the account to compound for longer and getting a bigger tax benefit as a result, because the earnings are tax-free for qualified expenses.

If an advanced degree is a possibility, remember that graduate school is also a qualified 529 expense. You can also transfer the funds to a beneficiary, such as a sibling or even yourself, tax-free and without penalty.

3. Receive a scholarship payment through a 529 plan. Another option would be to have a private scholarship provider award the scholarship as a contributions to the recipient's 529 college savings plan, instead of writing a check to the college or recipient. Mark Kantrowitz, an expert on student financial aid, scholarships, and student loans, wrote an article on outlining the advantages or disadvantages of having the scholarship provider pay the funds directly to the 529 plan.

One of the benefits of contributing a private scholarship to a 529 plan is that it effectively expands the qualified higher education expenses beyond tuition and fees and books and supplies: In particular, amounts spent on room and board will also be tax-free, if the student is enrolled at least half-time, Kantrowitz said.

In addition, contributing the scholarship money directly to a 529 plan would circumvent the problem of "scholarship displacement," which happens when a college or university reduces the amount of financial aid the student has been awarded by the amount of the private scholarship.

"About a fifth of colleges reduce their own grants when a student wins a private scholarship, yielding no net financial benefit to the student. That is a dollar-for-dollar reduction in aid eligibility," Kantrowitz says.

Routing the private scholarship funds through the 529 account also may help maximize future financial aid eligibility. Scholarship money (when not paid from a 529 account) that is used to pay for room and board and any books or supplies that are not specifically required for coursework is likely taxable; thus, it must be reported as student income on the Free Application for Federal Student Aid. This leads to a larger reduction in the amount of aid a student may qualify for in future years, which could be as much as 50% the amount of the scholarship that is taxable.

When a private scholarship is contributed to a 529 college savings plan that is owned by the student or the student's parents, however, the scholarship is reported as a parent asset on the FAFSA. Putting the scholarship money inside the 529 could reduce the impact to student aid because parent assets reduce eligibility for need-based financial aid by a much smaller percentage (5.64%) of the asset value than student income.

Of course, there are downsides. Notably, there's nothing (other than the 10% tax penalty and ordinary income taxes due on the earnings portion of the distribution) preventing the 529 account owner from using the funds for something other than the student's college expenses.

Another possible downside, depending on how you look at it, is that the scholarship funds could also be used to pay for college expenses for someone other than the student who earned the scholarship. Per IRS rules, the account owner could change the 529 beneficiary from the scholarship earning student to a sibling or themselves tax-free and without penalty.

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