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Question about timing when taking a 529 Distribution for scholarship

grimssgrimss Registered User Posts: 21 Junior Member
Because of luck and our children's hard work, the 529 plans we've been contributing to literally since the day our twins were born are likely overfunded because of scholarships they have received. In my daughter's case, for example, four years of tuition/room & board etc. will run just under half of what we have saved in her 529 account.

I understand that you need to withdraw 529 funds during the calendar year they are used to pay for qualified higher education expenses. In the case of an unqualified distribution not subject to penalty (i.e. scholarship reimbursement), does the same rule about calendar year usage apply? I've read elsewhere that scholarship distributions aren't subject to specific time periods, and thus one could/should claim the full year's scholarship amount in one lump reimbursement, rather than taking it in two payments over the school year (Fall 2018 and Spring 2019). While we certainly intend to leave sufficient overage in the 529 accounts for study abroad, unexpected costs, and possible graduate school, it certainly would be nice to reclaim some funds that won't be needed. :()

I've read through any and all related threads and can't find an answer. Thanks in advance for any help!

Replies to: Question about timing when taking a 529 Distribution for scholarship

  • BelknapPointBelknapPoint Registered User Posts: 3,459 Senior Member
    I understand that you need to withdraw 529 funds during the calendar year they are used to pay for qualified higher education expenses. In the case of an unqualified distribution not subject to penalty (i.e. scholarship reimbursement), does the same rule about calendar year usage apply?

    Not that I am aware of. There is no statute or IRS rule or regulation that I am aware of, and no IRS publication that I have read, that requires a non-qualified 529 distribution to be taken in the same year that a scholarship is received in order to benefit from a waiver of the 10% additional tax. I have also never heard of the IRS denying a waiver of the 10% additional tax because the scholarship and non-qualifying distribution did not match up in the same year.
  • grimssgrimss Registered User Posts: 21 Junior Member
    Thank you, @BelknapPoint. Much appreciated.
  • billcshobillcsho Registered User Posts: 18,405 Senior Member
    You may treat part of the scholarship as taxable income and then pay the QEE with the 529. However, I would not recommend making the taxable scholarship more than the deductible limit. You may want to keep the remaining money in the account until your kid finished all schools. Then you may consider if you want to change the beneficiary in the future.
  • grimssgrimss Registered User Posts: 21 Junior Member
    @billcsho, thank you for your recommendations. When you reference not making the taxable scholarship distribution more than the deductible limit, are you referring to the American Opportunity LL credit? Our family is phased out of that deduction, unfortunately. My current thinking is to take a one-time distribution of a single year's worth of scholarship funds from each 529, and then use that money to fund college spending accounts and and perhaps buy a car (my son and daughter currently share one car, but will be going to different schools). Presumably, given that there appear to be no time restrictions on additional scholarship distributions, we can reclaim any overage at the end of four years as taxable income if it's not needed for graduate school. All this is so new to me; it feels strange after all these years of 529 saving to actually start spending!
  • Curious6789Curious6789 Registered User Posts: 4 New Member
    Please keep in mind that while you can withdraw scholarship-equivalent amount from 529, only the part of the amount that goes towards QEE (tuition, fees and books) will be nontaxable. The rest (say the part of the scholarship what went towards R&B) will be taxable income and you pay 10% penalty on that.
  • BelknapPointBelknapPoint Registered User Posts: 3,459 Senior Member
    Please keep in mind that while you can withdraw scholarship-equivalent amount from 529, only the part of the amount that goes towards QEE (tuition, fees and books) will be nontaxable. The rest (say the part of the scholarship what went towards R&B) will be taxable income and you pay 10% penalty on that.

    This is not accurate. Only the earnings portion of a non-QEE distribution (not the whole amount) is subject to income tax, and to the extent that a non-QEE distribution can be offset by a scholarship, the 10% penalty does not apply.
  • Curious6789Curious6789 Registered User Posts: 4 New Member
    You are correct on the first part: only the earnings portion of the non-QEE distribution is subject to income tax. The 10% penalty applies to the earnings portion of the scholarship that was not tax-free. You can only offset a non-QEE distribution by a scholarship only if the entire scholarship is considered tax-free.

    Here's the wording from pub 570:

    Generally, if you receive a taxable distribution, you also
    must pay a 10% additional tax on the amount included in
    income.

    Exceptions. The 10% additional tax doesn't apply to the
    following distributions: Included in income because the designated beneficiary
    received: A "tax-free" scholarship or fellowship grant.
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