I opened 529 college-savings accounts for both of my grandsons. One of them just won a four-year scholarship to college. If I don’t use the money for college expenses, do I have to pay a penalty?

Generally, if you withdraw money from a 529 for anything other than eligible college expenses, the earnings portion of each withdrawal will be subject to income taxes and a 10% early-withdrawal penalty. (When you take money out of a 529, earnings and contributions are withdrawn proportionately.) However, there are several circumstances in which you avoid the penalty.

One is if your child isn’t using the money because he or she received a scholarship. In that case, you can withdraw up to the amount of the scholarship from the 529 without paying a penalty, although you’ll still have to pay income taxes on the earnings. 

Before you pay taxes on the withdrawal, first see if you can use the money for other eligible expenses. For instance, even if your child received a scholarship for full tuition, you can use the 529 money tax-free for required books and supplies, fees, and room and board. You can even use 529 money tax-free for room and board if your child lives off-campus, as long as he or she is attending college at least half-time. You can also use 529 money tax-free for a computer, printer, other related equipment and Internet access (the college student must be the primary user). 

There’s no time limit for taking withdrawals, so you can keep the money in the account if one of your grandsons decides to take time off and go back to college later on. Or you can switch the beneficiary of the 529 to another eligible family member. Eligibility is based on the relationship to the beneficiary. Eligible family members include the beneficiary’s spouse, child, sibling, parent, aunt or uncle, niece or nephew. 

See IRS Publication 970, Tax Benefits for Education, for the full list of eligible beneficiaries and more information about eligible 529 expenses (the “Qualified Tuition Program” section focuses on 529s).

Copyright 2016 The Kiplinger Washington Editors


This article was written by Kimberly Lankford, Contributing Editor and Kiplinger’s Personal Finance from Kiplinger and was legally licensed through the NewsCred publisher network.