If your child receives a full or partial scholarship to college, you can withdraw funds in your 529 account up to the amount of the scholarship each year and use the funds for a non-educational purpose without incurring the 10% federal penalty that would normally apply to the earnings portion of the withdrawal. In order to avoid the penalty, the withdrawal must be made in the same year that the scholarship is received and must not exceed the amount of the scholarship.
However, you will still owe federal (and possibly state) income tax on the withdrawal. Each withdrawal is pro-rated between contributions and earnings; only the earnings portion is taxed (at ordinary income tax rates).
Withdrawing funds in this situation isn’t your only option, though. You can leave the funds in the 529 account for your child’s future use, such as graduate school. Or you can change the beneficiary of the 529 account. If the new beneficiary is a family member of the original beneficiary, you won’t owe federal income taxes or a penalty when you make the change.
Note: Before investing in a 529 plan, please consider the investment objectives, risks, charges and expenses carefully. The official disclosure statements and applicable prospectuses — which contain this and other information about the investment options, underlying investments and investment company — can be obtained by contacting your financial professional. You should read these materials carefully before investing. As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated. Investment earnings accumulate on a tax-deferred basis, and withdrawals are tax-free as long as they are used for qualified higher-education expenses. For withdrawals not used for qualified higher-education expenses, earnings may be subject to taxation as ordinary income and possibly a 10% federal income tax penalty. The tax implications of a 529 plan should be discussed with your legal and/or tax advisors because they can vary significantly from state to state. Also be aware that most states offer their own 529 plans, which may provide advantages and benefits exclusively for their residents and taxpayers. These other state benefits may include financial aid, scholarship funds and protection from creditors.