Updated on September 22nd, 2021
At this point, most parents have heard about 529 plans. Perhaps you’ve even used one to save for your child’s college expenses. These college savings plans give families the ability to stash some cash away and earn tax-free interest to help their student pay for college expenses.
One of the biggest questions parents have about 529 plans is “Are scholarship worth applying to if my student has a 529 college savings plan?”
The answer is undeniably yes.
What if you could unlock that money for non-education-related expenses? And more importantly, how can you do this without paying a penalty on the money?
There is an important scholarship exception that dictates your options should your child not need all of their 529 plan to pay their costs. Here’s what you need to know.
*Please note: We are not Certified Financial Planners. You should always consult with a certified financial advisor and CPA before making any withdrawals or changes to 529 plans and other investment tools.
Money in 529 Plans Never Disappears
First and foremost, no matter what happens, you never lose the money in 529 plans if your child either doesn’t go to college or doesn’t use all of the funds for college-related expenses.
Plus, since they are funded with after-tax dollars, you don’t incur any penalties or additional taxes if you withdraw the money you contributed, even if it is for another purpose.
Now, you can be responsible for taxes on any earnings and may owe an additional 10 percent penalty depending on how the funds you withdraw from any 529 plan will be used. But, the important thing is that the funds never disappear, even if they aren’t used for college expenses.
If you do remove funds from a 529 plan that are being used for something other than qualifying college expenses and are subject to the tax liability, Melissa Sotudeh, a CFP® and Wealth Advisor at Halpern Financial, shared this advice about who should take on the tax liability associated with the withdrawal:
“It is recommended that when requesting a distribution that it is issued to the beneficiary so that the liability falls to the beneficiary. Typically, the beneficiary child will have a lower tax rate than the account owner (usually the parent).”
So even though you will have to pay the capital gains tax on the money, there are strategies to help reduce that amount.
Most importantly, there is a way around the 10% penalty and it has to do with scholarships.
Scholarship Exception on 529 Plan Penalties
A surprising number of people don’t realize that the 10 percent withdrawal penalty doesn’t apply if your child doesn’t use money from their 529 plans because they got a scholarship.
The special exception for scholarship recipients who also have 529 plans allows funds to be removed from the college savings plan without penalty up to the amount of the tax-free scholarship.
For example, if your student gets a $2,000 scholarship that will be applied to their college expenses, $2,000 can be pulled from their 529 plans without incurring a 10 percent penalty.
Again, it is important to note that you will owe taxes on the earnings after the withdrawal, so keep that in mind before you remove the funds.
But, paying taxes on the earnings shouldn’t discourage your child from applying for scholarships, as this allows them to reduce the amount of money you or they have to contribute, lowers the odds that they’ll need student loans, and gives you both new options for using the money.
Having your child apply for scholarships and freeing up their 529 plan money means you can do many things with the money beyond pay for college.
One idea we’ve seen parents implement is investing the money into a rental property that their child lives in for free throughout college while their roommates cover the mortgage. This is building wealth, saving you money, and using funds you already socked away!
You could also use it to pay down other debts, make a large purchase (like a car) more manageable, or even start an IRA for your student.
The options are endless!
Overall, scholarships are a fantastic way to free up this money you’ve saved. Here are a few more ways you can use the 529 plan money should your child not need it because of scholarships!
- Should Parents Pay for College?
- How to Pay for College When Striving for Financial Independence
- How to Get Started with Scholarships
Other Options for an Untapped 529 plan
Even if your student gets enough in scholarships to pay for all of their college expenses, you don’t necessarily have to pull any money out of their 529 plans. There are other options for handling this money.
First, you can change the beneficiary associated with any 529 plans to another family member!
So, if you have another child who is planning on going to college, or even if you are considering heading back to school yourself, that 529 college savings plan can help pay for those expenses even if the plan was originally for another family member.
Essentially, other children, parents, grandparents, nieces or nephews can be labeled as the new beneficiary without anyone incurring a tax penalty. And, the funds can now be used to pay tuition at certain private elementary and high schools, giving you more options for making the most of the money.
Some may assume that selecting a new beneficiary is a difficult or cumbersome process, but Melissa Sotudeh asserts that isn’t the case:
“Actually, the ease of assigning a new beneficiary is one of the great advantages of 529 Plans. Generally all you need to do is complete a form.”
If you want to see a full list of eligible potential beneficiaries, here is what the IRS has to say on the matter: https://www.irs.gov/publications/p970#en_US_2012_publink1000178575
Your second option is to leave all of the funds in their 529 plans intact.
At this time, there is no limit regarding how long funds can still in a 529 college savings plan and there is no age limit associated with the person who ultimately uses the cash. This means you can let the money grow until you find a purpose for it.
This can be ideal if your child received scholarships for their undergraduate degree, but may consider pursuing a graduate degree at a later time.
A lot of people leave school, either with or without a degree, only to return at a later time. Sometimes, it’s to advance their education, but others also head back to help facilitate a career change. While no one assumes that they will “abandon” their original career path, it certainly happens. So, if your child had doubts about their chosen field, 529 plans can also help support additional education if they decide to change directions in life.
Don’t Forget – 529 plans Can Be Used for More Than Just Tuition
It’s also important to remember that money in a 529 can be used for a range of qualifying expenses, not just tuition.
The costs that qualify are outlined in Internal Revenue Code Section 529, though typically includes:
- Eligible Equipment and Software
- Mandatory Fees
- Specific Room and Board Costs
Melissa Sotudeh was able to provide some clarity regarding what equipment and software can be purchased with funds from 529 plans:
“Computers and tablets are now qualified educational expenses, but only software that is required for the course of study can be paid for with 529 funds. Parents may not realize that equipment necessary for a student with special needs to enroll at a college or university is considered a qualified expense for 529 Plans.”
As with most things related to taxes, the IRS rules surrounding eligible expenses can be somewhat complex. If you have additional questions, the IRS produced a handy Q&A focused on some common questions. You can find it here: https://www.irs.gov/newsroom/529-plans-questions-and-answers
So Should We Apply for Scholarships?
Ultimately, just because you’ve saved for your child’s education using a 529 plan doesn’t mean they shouldn’t apply for scholarships. If anything, hopefully you now realize that it’s extremely beneficial for them to apply! Scholarships can help free-up your hard-earned cash to either help pay for another child or put the money to use in other ways.
If you and your child would like to learn more about how to get started with scholarships, sign up for our free college scholarship webinar! We cover exactly where to find these debt-free monies that could possibly free up your cherished 529 plan cash.
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