Taxes on 529 withdrawal due to scholarship

[Curious6789]

Hi Folks,

My son's college cost per semester was $15K. He got $8K in scholarship. We paid the remaining $7K out of his 529 (directly to college). I understand that there are no taxes due on the $7K. We also withdrew $8K from 529 because we can withdraw up to scholarship amount without any penalty. Out of the $8K, let's say $6K is from contributions and $2K is from earnings. Does my son pay taxes on the $2K earnings part? Or does he pay on the whole $8K?

When I see the college statement, it appears that they matched most of the scholarship amount to room & board. About $7K out of the $8K scholarship went towards R&B with the rest going towards fees.

Thank you very much for your help!! I really appreciate it!

[dcandmc]

Only the earnings portion of the 529 non-qualified distribution is taxable. Be aware that any part of a scholarship that pays for room and board will be taxable to your son.

[Curious6789]

Thank you very much! So the earnings part of the $7K is taxable to my son.

As far as R&B, if I pay college from 529, it is a qualified expense, but if I use scholarship to pay for it and withdraw from 529, it's taxable?

[dcandmc]

Room and board is not a qualified expense for tax-free scholarships, but it is a qualified expense for 529 money (if the student is enrolled at least half-time). It's up to you, not the school, to determine how the available funds that pay all the expenses will be allocated. So it generally makes sense for scholarship/grant money to be used first for tuition and qualified fees, and not be taxed on that scholarship/grant money, and use 529 money on room and board.

[Curious6789]

For whatever reason, the amount "billed" by the college was mostly for tuition and fees. They applied scholarship amount to R&B first.

Didn't know it's up to us and not the school to determine which funds are used to pay for which expenses! Has there been any guidance on it from IRS? Or, is it vague enough that it's subject to interpretation?

Thank you very much, @dcandmc!!

[dcandmc]

I should have added the caveat that sometimes scholarship or grant money will be restricted to a certain use, or prohibited from certain uses, so you may have to work within designated limits. But other than that, it's generally up to you to decide what money will fill the various "buckets" that are the different expense categories.

If your son's $15k in direct billed semester costs were, say, based on $10k in tuition and fees and $5k in room and board, it would make sense to have the $8k in scholarship money go towards the tuition and fees, and have the $7k in 529 money cover the remaining $2k in tuition and fees plus the $5k in room and board. That way, there is no tax owed on anything (the scholarship money is all tax-free, and the 529 money has been used 100% for qualified expenses).

[Curious6789]

Thank you again, @dcandmc!!

It turns out that about $7K was for tuition/fees, $7K for R&B and almost $1K was for books, computer etc. I assigned the scholarship money to tuition/fees and books, which together came to $7,995. So $5 became the distribution. Taking $3 contribution out of it, the taxable income became $2!

My son had earned income of around $1,500 last year. This extra $2 isn't going to make any difference from filing perspective. I may still go ahead and file the return just to acknowledge to IRS that 1099-Q and 1098-T were accounted for.

[Curious6789]

By the way, TurboTax does not do a correct job of handling 529 distributions and their taxation. I had to manually adjust the numbers based on my paper calculations to get to the right taxable income.

[dcandmc]

It turns out that about $7K was for tuition/fees, $7K for R&B and almost $1K was for books, computer etc. I assigned the scholarship money to tuition/fees and books, which together came to $7,995. So $5 became the distribution. Taking $3 contribution out of it, the taxable income became $2!

If $5 of scholarship money was spent on non-qualified expenses, the full $5 should be taxable. Scholarship and grant money is not broken up into a contribution part and an earnings part.

[Curious6789]

Hi @dcandmc, that was actually my original question on this thread. We withdrew the amount equal to scholarship from our 529 account because we could according to 529 rules. So, it's a 529 distribution, which should be split into contributions and earnings. Am I missing something?

[dcandmc]

Your son received a scholarship in the amount of $8k. $7,995 of that was spent on qualified (for a tax-free scholarship) expenses: tuition, mandatory fees, and books. That leaves $5 of the scholarship that will be taxable.

Room and board was $7k, which you paid with 529 money. That works, because room and board is a 529 qualified expense. It sounds like you withdrew an additional $8k from the 529 because of the $8k scholarship that was received. You can avoid the additional 10% tax on that non-qualified 529 withdrawal to the extent that it matches up to a tax-free scholarship. $7,995 of the scholarship was tax-free, so you can avoid the 10% additional tax on $7,995 of the non-qualified 529 withdrawal. If $2k (25%) of the $8k non-qualified 529 withdrawal represents the earnings portion of that withdrawal, tax will be paid on $2k, and the additional 10% tax will be paid on 25% of the amount ($5) that is not covered by tax-free scholarship.

[Curious6789]

@dcandmc, thank you for your continued help!! I appreciate it!

Are you saying that I have to pay tax on the earnings portion of withdrawal even if it went to pay for qualified expenses (tuition/fees)?

Also, even though $5 went towards nonqualified expense, my thinking is that I don't have to pay 10% penalty because it was a 529 nonqualified withdrawal due to a scholarship. If I didn't have the matching scholarship, I would have to pay the penalty for sure.

[dcandmc]

Are you saying that I have to pay tax on the earnings portion of withdrawal even if it went to pay for qualified expenses (tuition/fees)?

No. First of all, under the scenario we've been talking about, the tuition and fees part of the bill was paid for with scholarship money, not 529 money. There is no tax on any part of the 529 money that paid for room and board -- that's a 529 qualified expense. If you took an additional 529 withdrawal to match the scholarship received, none of that is qualified, and you must pay tax on the earnings portion of that withdrawal. You avoid the 10% additional tax, to the extent that the scholarship was tax-free. A small part of the scholarship was not tax-free, so the 10% additional tax will apply to the earnings portion of the 529 withdrawal that covered that small amount. And you also must pay tax on the small part of the scholarship that was not tax-free.

[dcandmc]

Also, even though $5 went towards nonqualified expense, my thinking is that I don't have to pay 10% penalty because it was a 529 nonqualified withdrawal due to a scholarship. If I didn't have the matching scholarship, I would have to pay the penalty for sure.

Not having to pay the 10% penalty only applies if the scholarship was tax-free. Not all of the scholarship was tax-free.

[Curious6789]

Thank you very much, @dcandmc!!

[Steve3317]

Does the student pay the tax? Is it then treated as ordinary income tax? I assume there's no capital gains involved

[dcandmc]

Does the student pay the tax? Is it then treated as ordinary income tax? I assume there's no capital gains involved

If the non-qualified 529 distribution was made payable to the student or the school, the earnings portion of that distribution will be taxable as ordinary income to the student. If it was made payable to the account owner, it will be taxable as ordinary income to the account owner.