My kid got a scholarship. What about her 529 plan?

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Q. I have a 529 college savings account. My daughter received scholarship from her college, and I understand that I can withdraw the scholarship amount without the 10 percent penalty, but must pay the federal and state taxes on the earnings. Must the scholarship withdrawal must be made in the same year as the college tuition? If not, is there a time limit to the scholarship withdrawal?
— Mom

A. Congrats on your daughter’s scholarship.

You’re right to question the rules.

According to the IRS, “generally if you receive a taxable distribution (from your 529 account), you also must pay a 10 percent additional tax on the amount included in income.”

But there are exceptions, said Deva Panambur, a certified financial planner with Sarsi, LLC in West New York.

Panambur said one of the exceptions to the penalty is if the taxable distribution is included in income “because the designated beneficiary received a tax-free scholarship or fellowship grant.”

Unfortunately, he said, the wording is not clear on the timing of the receipt of scholarship and of the penalty-free distribution.

“If your question is for scholarships expected to be received in the future, then you may want to take the penalty-free distribution in the same year as the scholarship, just to be safe,” he said. “For scholarships received in previous years, IRS rules does not explicitly state that you cannot avail of the penalty free distribution.”

Panambur said you should note that you can avoid both the penalty and income tax if you use the funds for your daughter’s future higher education, such as graduate studies.

You can also change the beneficiary to a qualified family member – including another child or yourself – and withdraw the funds for qualified education expenses without having to pay the penalty or the income tax.

“You also have the option of taking the distribution in your daughter’s name if she is expected to have a lower tax rate,” he said.

Email your questions to moc.p1545142168leHye1545142168noMJN1545142168@ksA1545142168.