When it comes to college planning, most out there defer to saving for college in a 529 plan. After all, the contributions in the account will grow tax-deferred and if withdrawn for Qualified Educational Expenses the growth of the contributions will be tax free. However, if the funds are withdrawn for anything other than qualified educational expenses then you may be subject to a 10% penalty on any investment gains.
A common situation arises when a student receives a scholarship and the parents have saved money in a 529 plan. When a 529 beneficiary receives a scholarship, amounts equal to the tax-free portion of the scholarship can be withdrawn without any 10% penalty. Generally speaking, scholarships that cover tuition or course-related expenses are not taxable to the student. If the scholarship is for room and board or exceeds tuition and course related expenses, it can become taxable income to the student.
There is a special provision that allows students who receive tax-free scholarships to withdraw amounts from 529 plans for non-educational expenses without penalties. In other words, only scholarship amounts that apply to tuition or course related expenses can be withdrawn penalty free. It is also important to remember that in order to have the 10% penalty waived you cannot wait until the last year of college to withdraw the scholarship money.
Rules like these surrounding 529 plan distributions are not well known, and there may be others that are unique to your specific needs. If you need help planning for your child’s college education please contact a member of our wealth management team.