Scholarship withdrawal from 529 tax free

prinehart 2018-07-18 20:34:35 UTC #1

My son earned numerous scholarships and is about to start his 2nd year of college, full time. He has a guaranteed scholarship that grows each year from his university, an honors scholarship and two private scholarships. We have Coverdell money and 529 money saved. We were advised to spend his Coverdell money first. We withdrew Coverdell money last year that covered some tuition and all of his room/board. This year, his scholarships will cover more than his tuition. We will have most of the 529 money ($24,000 - of which only $4200 is earnings) left over if we continue to spend his Coverdell and he continues to receive the guaranteed amount.
Do I have to withdraw scholarship money from a 529 in the year the scholarships were granted, or can I wait and withdraw a cumulative amount his senior year. I have searched for this information and cannot find an answer on any site, IRS or otherwise.

dcandmc 2018-07-19 02:40:51 UTC #2

The IRS is silent on any timing requirement as to 529 withdrawals taken because of scholarships received, so that the "additional tax" penalty can be avoided.

prinehart 2019-03-13 20:14:25 UTC #3

UPDATE Question:
So, I just got off the phone with my tax preparer and am a little shocked. I thought I had done everything the right way. We had $11,800 in qualified expenses. I withdrew $10,800 from a Coverdell account to cover these expenses. Son received $10,000 in scholarship. I also withdrew $3700 as a non-qualified expense from his 529 plan as "scholarship", of which $660 is taxable interest.
Tax preparer said that there is a formula that adds up ALL withdrawals and ratios them proportionally. So now I am possibly going to have to pay tax on $2100 instead of $660. (If I hadn't taken the 529 "scholarship" there wouldn't be a problem)

My question is: How do I effectively withdraw the 529 money as a scholarship? (especially if I cannot take Coverdell and 529 distributions in the same year due to this worksheet requiring all distributions to be lumped together.)
One plan would be to use up the Coverdell first, but then the entire 529 would be left untouched. (I know … good problem to have.) Son earned this money through his studies to be awarded the scholarships. The money is his. I won't be transferring it to his sister. I want him to be able to receive all of it and I don't want to be hit with extra taxes because I saved. I am unable to take advantage of any tax break (AOT or other ed tax benefits).

Any help as to how to withdraw scholarship money would be appreciated.

baseball2 2024-02-03 21:52:43 UTC #4

Hi there. How did this get resolved (How do I effectively withdraw the 529 money as a scholarship?)? I'm in the same boat with a daughter who has received 17K in scholarships her freshman year. I used her 529 to pay her tuition balance. We would like to make a scholarship withdrawal from the 529 (around 10k). I was thinking I would do it in my name rather than hers. It's my understanding that I will have to pay tax on the earnings, but not the usual penalty incurred on non qualified withdrawals. Any tips?

dcandmc 2024-02-04 19:09:40 UTC #5

For the 2023 tax year, in order to take a non-qualified distribution from a 529 account that is not subject to the 10% additional tax ("penalty") because the distribution is matched to and does not exceed a tax-free scholarship that the student previously received:

Report the earnings portion of the non-qualified 529 distribution on line 8z of IRS Form 1040 Schedule 1. This will flow through to line 8 of the 1040.
On line 5 of Form 5329, report the amount you already entered on Schedule 1 for the non-qualified (but penalty free) earnings portion of the distribution from the 529. On line 6 of the Form 5329, enter the same amount as you entered on line 5.
Subtract line 6 from line 5, and you get zero, which is entered on Form 5329 line 7 and is the amount of the earnings portion of the non-qualified 529 distribution that is subject to the penalty.

Since the earnings portion of the non-qualified distribution is reported on the tax return of the person who received the distribution (you as the account owner or your daughter as the beneficiary), you may want to make the distribution payable to your daughter, as she is likely in a lower tax bracket than you and would therefore pay less tax on the earnings portion of the distribution. And depending on other reportable income she may have, if any, the distribution may cost her nothing in tax if it's covered 100% by her standard deduction.

Edited to add: see IRS Pub 970 Chapter 7, where all of this is explained- https://www.irs.gov/pub/irs-pdf/p970.pdf