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Balancing Your Scholarships and 529 Plans

Sep 22, 2017

For 18 years, you have diligently saved for your kid's education employing a 529 plan, building up a substantial amount, and yet your kid has gotten a scholarship, so now what? First, congratulations, both you and your kid have much to celebrate! Now what should you use the excess 529 funds for to lessen penalties and tax?

529 Plans Pay for More Than Just Tuition

To start with, note that section 529 funds may be employed for more than only tuition and charges-- other expenses qualify as well. This incorporates schoolbooks, online cost, a laptop and any computer software utilized mainly for schooling. Then there is the big one, room and board for your college student if enrolling in a minimum of half time.

Not residing on campus? Not a problem! Schools yearly release a "cost of attendance" estimate for each academic year, which features the approximate cost of room and board. You can make tax-free distributions from a 529 plan as high as this cost for a college student not residing on campus. For college students actually living on campus, if this cost goes beyond the quote in the expense of attendance, the true cost invested can be dispersed.

529 Plan Money Still Left Over? 

Still going to have money left? There are a couple of other possibilities. Initially, if there is another kid you want to select as the recipient, the accounts can be moved between brother or sisters, and even to a significant other or first cousin, however make certain that the recipient has changed prior to making distributions for the newly selected student, or this can trigger you tax headaches in the future.

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If there is no other prospective recipient, any excess amounts as much as the amount of scholarships earned can be withdrawn without cost; nevertheless, any earnings on the withdrawal would be vulnerable to tax. See the following example:

Tom has a scholarship that takes care of all tuition yearly, which is presumed to be $10,000. Sam's parents have saved carefully and, even after making withdrawals for room and board, they are anticipating to have $40,000 left over in the account, as it was the amount anticipated for university tuition ($10,000 x 4 Years = $40,000).

In year 1, $10,000 above the amount for room board and other costs is withdrawn. The 10% penalty does not apply, as Tom has scholarships of $10,000, which is what created the overfunding in the 529 plan. At the moment of withdrawal, 60% of the account is contributions, 40% is profits. As the beneficiary of the account, Sam will pay income tax on the $4,000 in gains that are withdrawn.

In year 2, $11,000 (55% contributions, 45% gains) above the amount for room and board and other costs is withdrawn. Tom has $10,000 in tuition and fees, all which is paid for by a scholarship. For this case, the gains portion of $1,000 ($1,000 x 45%=$450) of the $11,000 is subject to a 10% penalty for being a distribution surplus of the amount of scholarship covered expenses, which in this case would be $45 ($450 x 10%). $4,950 ($11,000 x 45%), the amount of gains from the distribution, is likewise subject to income tax.

Get Expert Help

Thankfully, college students are typically in a lower tax bracket, which minimizes the tax sting a bit. If you will make 529 plan distributions, talk to your tax expert to set the most effective course to lessen the tax ramifications of distributions, together with taking full advantage of any academic credits for which you may qualify.

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