You have done an excellent job saving for your child to go to college – in fact you have accumulated close to $200,000 in assets in a 529 college savings plan. The acceptance letters start rolling in and you find out your son or daughter gets a full ride scholarship to their school of choice.
Great news! You probably plan a party to celebrate – but you realize $200,000 of your wealth is locked up in the 529 plan. What can you do?
When taking money out of a 529 plan for expenses not related to higher education you generally will have to pay a 10% penalty and federal income taxes on the earnings in the account. If you received some sort of state tax deduction or credit when you made the contributions to the account you will likely have to pay state taxes as well.
However, given your child received a scholarship, you can withdraw up to the scholarship amount without having to the pay the 10% penalty. You will still have to pay income taxes on the earnings, but a 10% savings on the earnings alone can be meaningful.
Before making any withdrawals, you should review the fine print of the scholarship to see exactly what it covers. Usually there are additional tuition fees, books, supplies, or maybe room and board that is not covered under the scholarship - these expenses can be funded with a 529 plan without any taxes or penalties. Do not forget to keep all your receipts as well – the cost of a computer, printer, internet access, or other supplies can be funded by a 529 if the equipment is primarily used by the student.
Even if your child decides to live off campus, if he or she is attending college at least half the time you can tap the 529 plan tax-free for the cost. Keep in mind, when paying for off-campus housing, you can only fund the cost tax-free from the 529 up to the amount the college specifies as the full room and board figure in its cost of attendance for federal financial aid purposes.
You also can save the funds in the 529 if your child may have plans to attend graduate school, or save the funds and transfer them to your son or daughter to be used for their children. One of the unique benefits of a 529 is that you can transfer the plan to a new beneficiary. Depending on your situation, it may be more beneficial to preserve the $200,000 over the next 20+ years until your grandchild may be attending college. A $200,000 529 plan earning on average 7% could accumulate to close to $774,000!
Don’t forget that a parent can also change the beneficiary to be themselves. This could be an option if one, or both, of the parents would like to attend college.
You have many options for 529 plan assets if your child gets a full, or partial, scholarship. The most important takeaway here should be don’t make a snap decision and withdraw the money immediately and incur taxes and penalties. There may be some unique planning strategies you may be able to take advantage of to avoid these taxes.
To learn more about 529 plans and their benefits please contact your advisor.