Susan E. Thomas CPA
What happens to the funds in my 529 plan if my child gets a scholarship for college?

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: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Prepared by Broadridge Investor Communication Solutions, Inc, Copyright 2011