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Scholarships and 529s

Joseph Hurley, CPAMy husband and I have been putting money into a 529 plan for our daughter Jesse over the past couple of years and our account has grown nicely in value. Jesse started college this fall and we paid her tuition and other college bills with money from our checking account. We were fortunate that the college provided Jesse with an academic scholarship covering 65 percent of her tuition. Now we would like to withdraw money tax-free from the 529 plan to reimburse us for the costs we paid out of pocket. But we're not sure if we should also withdraw the amount of the scholarship. Can you help us?

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This is a tricky issue. The amount that can be taken tax-free from your 529 account is limited to the amount of qualified higher education expenses incurred by Jesse during the year. Anything more is considered a "non-qualified" withdrawal, reportable on your or Jesse's federal income tax return. The "good news" is that the normal 10 percent federal tax penalty on non-qualified withdrawals is waived when withdrawals are attributable to a scholarship.

If you are fairly certain that Jesse will incur enough qualified higher education expenses in future years to fully consume the funds in your 529 account, you may want to leave the scholarship amount in the 529 plan, and keep all your withdrawals tax-free. However, if you think there is a good chance you will end up with more money in your 529 account than is needed to pay Jesse's college costs, you may want to withdraw the scholarship amount now and avoid the risk that unspent funds become subject to the 10 percent penalty when withdrawn in the future. Just be sure to request that the 529 withdrawal be made payable to Jesse, not to you, so the 529 earnings are reported on her tax return and not yours (I'm assuming that Jesse, like most first-year college students, is in a low tax bracket.)

Unfortunately, the tax law is not clear on whether the penalty exception for scholarships applies only for the calendar year in which the scholarship is provided. It would be helpful if the IRS allowed you to count all scholarships received in prior years when determining the applicability of the 10 percent penalty for withdrawals in the current year, but the guidance we've received from IRS thus far does not address this issue. (The 2004 version of Publication 970 Tax Benefits for Education has just been released.)

Remember also that Jesse's qualified higher education expenses must be reduced by any tuition used in generating a Hope tax credit or the Lifetime Learning credit. This adjustment is sure to affect many families. The results are similar to the scholarship scenario described above: Although some of the withdrawn 529 earnings may become taxable, the amount attributable to the credit adjustment will not be subject to the 10 percent penalty.

"The information contained in this material and related materials ("Information") is based on information from sources believed to be accurate and reliable and every reasonable effort has been made to make the Information as complete and accurate as possible but such completeness and accuracy cannot and is not guaranteed. The reader and user of the Information should use the Information as a general guide and not as the ultimate source of information. The Information is not intended to include every possible bit of information regarding the Information but rather to complement and supplement information otherwise available and the reader and user should use the Information accordingly. The Information contains information about tax and other laws and these laws may change. The reader and user should realize that any investment involves risk and the assumptions and projections used in the Information may not be how the investments turn out. The reader and user should consult with their own tax, financial and legal advisers about all of the Information."
-- Posted: March 31, 2005




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