What Happens to Your 529 if Your Kid Gets a Full Ride Scholarship?

Saw your piece in USA Today, July 30, ’16. ‘Earning a scholarship creates an exception to the 10% penalty rule for non-qualified withdrawals.’

Luckily we’re in that situation.

Question: Does a non-qualified withdrawal equal to the scholarship have to be drawn out in each of the same years in which the scholarship is actually applied in order to qualify for the exception? Example: Our son gets an 80K scholarship; 20K each year over 4 years. Do we have to make non-qualified withdrawals of 20K in each of those same years to avoid the tax, or could we, for instance, wait until he graduates or maybe even a year or two later and then draw out 80K and still be exempted from the penalty tax?

IRS instructions don’t specify any time limitations that I could find so I think we would be OK with the latter scenario.

What’s your take?


*The following is not specific tax advice. Please contact your tax professional for assistance on matters similar to this or anything else tax related.*

“What happens to our 529 money if our kid goes to college and gets a scholarship? Do we lose the money?”

This question isn’t uncommon. It’s also perfectly reasonable. The short answer is, you’ve got options. One of those options is having the ability to withdraw money penalty-free up to the amount of the scholarship. You’ll still need to pay taxes on the gain portion of the withdrawal, but that’s reasonable.

This question goes a bit further by asking if scholarship offset withdrawals can be delayed until a future date. If this is, in fact, a legitimate choice it could provide a very valuable benefit to the owners of the account.

The first place we should look for an answer is IRS Publication 970 Tax Benefits for Education. I’m sure everyone has a copy of this on their nightstand at home. What? You don’t? Well, here’s a link. Chapter 8 of Pub 970 discusses Qualified Tuition Programs or QTPs. 529 accounts fall into this category, so this is where we want to go first. However, after reading through the guide, you’ll see that nothing is specifically stated regarding the timing of the scholarship offset distribution. There is a related example provided that shows the scholarship offset distribution happening in the current year the scholarship was earned, though. And that makes sense.  For example, if a partial scholarship was awarded and the family still needed to use some of their 529 savings, a calculation would need to be made to check and see if any part of the distribution became taxable once the scholarship was accounted for. You would need to run that calculation in the tax year it occurs in order to make sure you were square with the IRS.


Publication 970 doesn’t speak to that specifically. One could argue that means running the calculation as Publication 970 illustrates is more of common practice or knowledge rather than a requirement that can be definitively sourced and referenced. Hmmm.

After not being able to convince myself that I wasn’t missing something important, I reached out to the Indiana Education Savings Authority and ran the scenario by them. Surely, they’d chuckle at my naivete and send me back to my desk with an answer and a glass of warm milk, right?

That is not what happened.

They agreed with me. Publication 970 seems to indicate that the scholarship offset withdrawal should happen in the same year the scholarship is awarded but doesn’t go as far as implicitly stating it. So, like so many things tax-related, the final decisions on how aggressive the taxpayer wants to be lies with the taxpayer.

Ultimately, it might be best to compare both routes. Avoiding the penalty now might be attractive, especially since Indiana’s tax credit statute considers a scholarship offset-related withdrawal qualified and thus not subject to recapture of the state income tax credits received based on annual contributions. If you roll the dice and wait to take the distribution in the future, the tiny bit of ambiguity in the law may be erased. You’d then be taking a non-qualified withdrawal (i.e. emptying the account later if further education is not pursued) and would likely face more consequences. In particular, the state income tax credit recapture.

Or, you could go a completely different direction by not withdrawing the money and changing the beneficiary to another child, or even a future grandchild. Your accumulated education savings could potentially give a big jumpstart to another relative’s dream of furthering their education, impacting your descendants for generations to come.

I wish I could be more concrete, Roy. However, we’re 20+ years into 529 programs and we still don’t have definitive guidance from the Department of the Treasury on things like this. If I were in your shoes, I’d sit down with my tax preparer and/or financial advisor and talk about the options. I think it makes sense for most people to take the offset withdrawals as they occur, but your team of professionals can assist you in making the right decision for your situation.

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