One of the rules governing 529 savings plans, which parents typically use to help pay for a child's college education, is that when the earnings on those contributions are not used for qualified education expenses, they are subject to taxes and a 10% penalty. But it turns out there are ways to avoid the penalty. Here's a look at how these plans work and at the exceptions to the rules.

A 529 savings plan, or qualified tuition program (QTP) as it is officially known, provides tax advantages if you want to save for your child’s college education (and, since the 2017 tax bill, K-12 private education as well). Following the passage of the Setting Every Community Up for Retirement Enhancement Act (SECURE) of 2019, 529 funds may also be used to pay off student loans (up to $10,000) and these plans can fund eligible apprenticeship programs, too. QTPs are set up and run by individual states. While the rules are governed by IRS Section 529, plans differ in their details.

Contributions to a 529 plan are made after taxes, so no taxes or penalties are due when any part of the original contribution is withdrawn, no matter when that happens. Earnings are tax and penalty free so long as they are used for qualified educational expenses, such as tuition, fees, room and board, textbooks, and some computer equipment. Earnings used for nonqualified expenses are subject to taxes, and they are also typically subject to a 10% penalty, though, as noted above, there are exceptions.

Key Takeaways

  • 529 plans are a way to pay educational and, in some cases, vocational expenses, and even pay back student loans without paying taxes or a penalty on qualified withdrawals. 
  • You never pay taxes or a penalty for the portion of a distribution that represents your original contribution, no matter when you take it.
  • If your child receives a scholarship, you may withdraw that exact amount from a 529 plan and use it for anything without incurring a penalty on earnings, but you must pay taxes on the earnings.
  • The timing of penalty-free earnings withdrawals is the subject of debate among tax experts.

529 Withdrawal Penalty

If you take a distribution from your child's 529 plan and use some or all of it to cover nonqualified expenses, you will owe not just taxes but, in most cases, an additional 10% penalty on the taxable portion of those earnings. (Keep in mind that the plan administrator will apportion the distribution to include mostly original contributions but also some earnings.) Here's an example:

If your child has $5,000 in adjusted qualified educational expenses (AQEE) but you take a distribution of $6,000, you now have $1,000 in nonqualified expenses. If the earnings portion of your original $6,000 distribution is $900, you will owe taxes and a 10% penalty on $150, calculated as follows:

$900 (earnings) x $5,000 (adjusted qualified education expenses) / $6,000 (distribution) = $750 (tax-free earnings)           

$900 (earnings) - $750 (tax-free earnings) = $150 subject to taxes plus penalty

Note that in the example above you will pay no taxes or penalty on the portion of the distribution that represents your original after-tax investment ($5,100) and no taxes or penalty on the portion of earnings that is considered tax-free ($750).

Exceptions to the 10% Penalty

There are several situations in which the 10% penalty on taxable earnings does not apply. These include a distribution taken when the beneficiary: dies; becomes disabled; attends a U.S. Military Academy; or includes the distribution in income because qualified education expenses were used to determine the American opportunity or lifetime learning tax credits. Additional exceptions exist if your child receives certain types of educational assistance. One of these is known as the scholarship exception.

The Scholarship Exception

If your child receives a tax-free college scholarship or grant, the amount of that scholarship or grant must be deducted from total qualified education expenses as part of the determination of their adjusted qualified education expenses (AQEE).

The scholarship exception, however, lets you withdraw up to the amount of that scholarship and use the money for any purpose penalty free. The earnings on that portion of the distribution will still be subject to income tax. But if you use the withdrawal for qualified educational expenses, the money will be both tax and penalty free. 

The scholarship clause is important because if your child does not receive a scholarship (or meet one of the other exceptions) and you withdraw funds that are not used for qualified education expenses, you will owe both taxes and a 10% penalty on the earnings.

A 529 plan is portable, meaning that it can be used state-by-state. If you transfer from one college to another, the funds travel with you.

The Time Limit Controversy

The timing of a 529 plan distribution based on a scholarship has been the subject of debate among tax experts since Section 529 was incorporated into Public Law 104-188 in 1996. That’s because neither Congress nor the IRS offers clear guidance on when the distribution can be made. This has led to a split in expert opinion ranging from “there is no time limit” to “you must withdraw the funds before your child graduates” to “the money must come out in the same calendar (tax) year the scholarship was received."

Enrolled Agent Rachel Murley of RKM Accounting and Tax LLC takes a somewhat constrained approach. “While the IRS does not offer guidance on this topic specifically,” Murley says, “like most things with the IRS, you must interpret between the lines.”

She points to IRS Publication 970, page 52, which says, “To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.”

Since “a school year and a tax year are not necessarily the same thing,” Murley says, one must figure education expenses using a tax year instead of an academic year. In other words, you must take the distribution in the same calendar year you receive the scholarship.

However, Peter J. Greco, CPA, founder and chief tax strategist at the CSI Group, believes you have more latitude when deciding when to take the scholarship distribution.

“Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense,” Greco says. “However, IRS 970 is silent as to when the money must be withdrawn. If Congress is trying to encourage 529 plans, then it makes good policy sense that the withdrawals can be made any time prior to graduation.

The Bottom Line

It's indisputable that you can take a penalty-free scholarship-based distribution from your 529 plan and use the money for any purpose. There remains a question about when you can take this distribution. Absent guidance from the IRS the following advice seems prudent:

  • If possible and to avoid any problems, take the distribution before the end of the calendar year in which the scholarship or grant was awarded.
  • If you want to delay taking the distribution beyond the calendar year as just noted, contact your plan administrator to make sure there are no state or plan rules that might impose a penalty.
  • At the same time, contact a trusted tax adviser for advice and counsel.

As always, remember that you can avoid the 10% penalty but not regular taxes on any exempt distribution of earnings used for nonqualified expenses.