27 May After scholarship, what happens to 529 plan?

Q. My sister has a 529 plan for my nephew, her son. He received a full scholarship – roughly $30,000 a year for four years. Can she withdraw the balance in her 529 plan – roughly $60,000 – for him at any time without paying the 10 percent penalty as long as the amount withdrawn is not more than $120,000? Or is the penalty exception only allowed in the same year that the scholarship was received? The IRS publication seems to say you can withdraw amounts up to the scholarship without the 10 percent penalty, but it doesn’t indicate a time period for withdrawal.
— Uncle

A. Congratulations to your nephew and your sister. It’s a great accomplishment.

To your question: If the 529 proceeds are used for qualified expenses over and above his scholarship, the withdrawals are penalty and tax-free, siad Altair Gobo, a certified financial planner with U.S. Financial Services in Fairfield.

He said you can take a non-qualified withdrawal from the 529 up to the amount of the scholarship without paying the 10 penalty.

“There seems to be no specific IRS guideline as to the timing regarding your sister taking the accrued value of his scholarship from his 529 plan currently or in future years,” Gobo said. “Typically you want to match withdrawals to the year in which the expense is incurred – conservatively your sister may want to follow the same logic regarding the scholarship.”

Although contributions are taken out tax- and penalty-free for non-qualified withdrawals, income tax must be paid on the earnings, Gobo said.

He recommends your sister should check with the 529 plan administrator to determine if your nephew can take the withdrawal himself, listing his name, not hers, on Form 1099 – thus making him responsible for paying the taxes.

“Presumably he is in a lower tax bracket than his mother, which can help lower the tax bill,” he said.

Keep in mind this 529 can be used in the future for grad school or any other qualified expenses such as tuition, room and board, books, supplies and mandatory fees, he said.

Also, your sister may choose another qualified beneficiary to receive the benefits of the 529 plan, Gobo said.

Be sure you understand the possible taxation of a scholarship, which changed with the new tax plan. Learn about that here, and then see what legislators are proposing to do about it.

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This story was originally published on May 27, 2019.

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