529 Plan Withdrawals and Prior Year Scholarships

[revenuecode]

If a non-qualified distribution is made from a 529 plan, it is generally taxable to the extent of earnings and a 10% penalty is added. But if a scholarship is received, a distribution can be made without the 10% penalty, For example, if for a student's freshman year, there is a $25,000 withdrawal is made in a year when a $10,000 scholarship was received and applied to a total of $30,000 of qualified education expenses (assume no AOC or tuition deductions), the withdrawal would have exceeded by $5000 the $20,000 of net remaining eligible expenses after scholarship, The $5000 would be taxable as to the 529 plan earnings included in the withdrawal, but there would be no 10% penalty. But what if the parents, rather than withdrawing $25,000 that year, only withdrew $20,000, because they wanted to avoid depleting the 529 account before they know that all college costs had been covered? Four years later, there is left in the 529 plan $5000. The parents withdraw it and want to avoid the 10% penalty on the taxable earnings by pointing to the freshman year scholarship and the "unused" protection against the 10% penalty from freshman year. Is that permissible? We're not talking about making sure that eligible expenses are counted in the proper tax year--all expenses were properly allocated. We are talking about parents not wanting to "waste" 529 money by withdrawing it too early rather than taking advantage of penalty-free withdrawals based on scholarships AFTER there are no college costs left to be paid. I can find no guidance on this, despite the wisdom of a tax policy that encourages parents not to withdraw 529 plan money until they are sure that it won't be needed just because a scholarship is received in a particular year. I can find no guidance on this. TurboTax does not make it easy to try to use a prior year scholarship to eliminate the 10% penalty in a post-graduation year that has no current eligible education expenses. Anyone confident of an answer either way?

[Critter]

The reason the program makes it impossible to do is because you cannot do it. Any amounts withdrawn after the student is no longer in school are subject to the penalty.  You should have liquidated the account in the final year of school or transferred the left over to another qualified family member. 

[Hal_Al]

To be a qualified distribution, the money must be withdrawn in the same calendar/tax year that qualified expenses were paid. Likewise, to be eligible for an exception to the 10% penalty, the distribution must be in the same year that the scholarship paid for expenses.

[revenuecode]

"You should have liquidated the account in the final year of school or transferred the left over to another qualified family member. "

Thanks for your answer.  Two questions, please. 

First, are you suggesting that if the scholarship was received freshman year, so long as the non-qualified withdrawal covered by the scholarship is made by the final year of school, it would not be subject to penalty?

Second, is there a written IRS instruction specifically addressing your conclusion as to deferred use of scholarships to avoid withdrawal penalties?  I know that eligible expenses need to be matched to 529 withdrawals annually, but that doesn't specifically cover matching scholarships to unqualified withdrawals.  For example, if 2018 scholarships are $10,000, AOC is $2,000, and eligible education expenses are $30,000, the maximum 529 plan reimbursement would be (30-10-2=) $18,000.  I believe you agree that $10,000 (equal to the full scholarship) could be withdrawn in 2018 without penalty.  But what if if in that scenario rather than reimbursing $18,000 from the 529 plan, only $10,000 of 529 plan assets were used for eligible expenses with $8,000 of eligible expenses covered from non-529 parental savings and only $2,000 were withdrawn from the 529 plan as a non-qualified withdrawal?  In effect, only $2,000 of the scholarship would have been used to avoid withdrawal penalty, and $8,000 of 529 plan assets that might have been used rather than other parental savings was (prudently) left in the plan.  If in 2023 after college graduation that $8,000 that could have been withdrawn without penalty in 2018 is withdrawn the correctness of eligible expense/529 reimbursement calculations in 2018 continue to satisfy all rules related to "matching" reimbursement of eligible 2018 expenses.  For 2023, the "matching" rules are irrelevant, because there are no eligible expenses being reimbursed.  A non-qualified withdrawal of $8,000 at that time, however, is equal to scholarship value that, due to non-use of 529 assets rather than other parental savings in 2018, created a "surplus" of 529 funds equal $8,000 that might have been withdrawn in 2018 but is not expressly under IRS rules no longer the basis for an unpenalized non-qualified withdrawal in later years.  I'm aware of nothing in the annual expense matching guidance that says that if the 2018 eligible expense matching was correct as to 2018 expense, there is any relevance of a second application of expense matching rules in 2023 when no 529 funds are being used to reimburse expenses because no expenses exist.  The "surplus" of $8,000 of unused 529 plan funds that might have been used rather than other parental savings in 2018 and that are less than the 2018 scholarship but not previously taken as an unqualified withdrawal in 2018 would not (in any IRS guidance I've seen) lose that non-penalizable status.  The policy reason supporting this view is that once that "surplus" is created, college savings is promoted and education better supported if the owner of the 529 account is not forced to withdraw the funds in 2018 in order to avoid penalties.  Otherwise, 529 funds might end up depleted early and fail to support graduation.

[revenuecode]

Hal_Al, please see my reply to Critter.  Thanks for your answer.

[Critter]

@Hal_Al   OP would like a response from you. 

[Hal_Al]

Q. Are you suggesting that if the scholarship was received freshman year, so long as the non-qualified withdrawal covered by the scholarship is made by the final year of school, it would not be subject to penalty?

A.  No.  To be penalty free, the withdrawal must be in the same year as the scholarship.

In your scenario of taking an $8000 529 plan distribution, in 2023,   the earnings portion (box 2 of the 1099-Q) of the $8000 would be both taxable and subject to the 10% penalty. See IRS pub 970.

[revenuecode]

Thanks for responding again.  I don't disagree that the amount ordinarily taxable for 2023 would be the $8000 withdrawal portion that was earnings and not principal, plus a 10% penalty.  However, there is no language in Pub. 970 that says that when scholarship money has been received (and used for eligible expenses that as a result did not consume 529 plan funds that otherwise might have been used), the avoidance of the 10% penalty can only occur for a withdrawal in the year that the eligible expenses were incurred.  Can you please direct me to the paragraph in 970 that you believe addresses the scholarship issue and speaks to the waiver of the 10% penalty only in the year the scholarship was received?

The silence of Pub 970 (failure to state that a scholarship used instead of 529 funds cannot be used to avoid penalty on otherwise unqualified withdrawals in future years) makes good tax policy sense.  It is not a tax-free withdrawal of the earnings portion of the withdrawal.  If the policy goal is to support higher education funding by encouraging 529 funds to remain in a 529 until all education expenses have been incurred, this is supported by not forcing parents to choose between withdrawing scholarship amounts from a 529 early in college (at a time when future financial aid and future 529 investment performance may be uncertain), but recognizing that a prudent parent that does not withdraw to offset scholarships each year but then does so at the end of college has used the 529 funds prudently and not abusively. 

The IRS has been in a position for years to give guidance against the silence of Pub 970 on later year withdrawals against prior scholarships and to my knowledge has not.   Nor can I find anything in the accounting literature that says that scholarships cannot be the basis for later year unpenalized 529 withdrawals so long as the scholarship was applied to eligible expenses.

If the scholarship is used to avoid the 10% penalty in a year after it was received, the taxpayer should be prepared to support that use with documentation supporting the correct application of the scholarship to eligible expenses (and of the 529 plan) in the year the scholarship was received.

[court]

@Hal_Al  @revenuecode 

Was there ever a solid answer as to where in the IRS code one can find that what it says about if scholarship money has to be withdrawn in the year it was awarded?  I just found out about the scholarship exemption, my son is a Junior. I would like to take extra money out of his 529 plan without the penalty so we can invest it for him.  It would be nice to go back and pull the money he received in 2017 and 2018 as well!  but if there are penalties involved I'll just pull 2019.  

thanks for your help!

[Hal_Al]

It seems to take a little "reading between the lines" in PUB 970, which has the following wording:

To determine if total distributions for the year are more or
less than the amount of qualified education expenses, you
must compare the total of all QTP distributions for the tax
year to the adjusted qualified education expenses.

Here's a good non IRS explanation:  https://www.savingforcollege.com/article/timing-of-529-plan-distributions-must-match-qualified-expen...

[Carl]

One thing that can really confuse people is the fact that the IRS works in calendar years, and educational institutions do *not*. Educational institutions work in academic years. So the reality is, it takes you five calendar years to get that four year degree.  It was when my daughter started her 2nd academic year in college that the light bulb clicked on over my head and I was able to see how the IRS has really simplified it.

 - Qualified education expenses are claimed deducted in the tax year they are paid. It *does* *not* *matter* what year was paid *for*.

 - Scholarships, grants, and 529 distributions are reported in the tax year they are received. It *does* *not* *matter* what year the scholarship, grant, or 529 distribution is *for*.

Now with it taking five calendar years to get that four year degree, here's where most people screw up.

The last semester of the senior year starts in the *fifth* calendar year. So if you wait until after the new year preceeding that semester to pay for tuition, books and lab fees, you may not get the AOC and other credits that are limited to four calendar years, if you took those credits in the preceeding four calendar years.  Here's a rundown.

 - Start freshman year fall semester in Sep 2015 and paid fall semester only. For 2015 you claim the AOC. That's one calendar year.

 - Start freshman year Spring semester in Jan 2016. Pay spring semester in 2016. Start Sophomore fall semester in Sep 2016 and pay that semester in 2016. That's the 2nd calendar year.

 - Start sophomore spring semester in Jan 2017. Pay spring semester in 2017. Start junior fall semester in 2017. Pay in 2017. That the 3rd calendar year.

 - Start junior spring semester in Jan 2018 pay in 2018. Start senior fall semester in Septemper 2018. Pay spring semester in 2018. That's the fourth calendar year.

 - Start senior spring semester in Jan 2019. Pay spring semester in 2019. Graduate in May 2019. That's the 5th calendar year and you can not claim the AOC or any other 4-year credits if you claimed them the previous 4 calendar years.

So the trick is, pay for the senior spring semester in full, *BEFORE* you go on Christmas break at the end of the senior fall semester. That way, you claim all your education expenses for that final year of college, for the tax year that the senior fall semester ends before Christmas. Then you will have "NO" education expenses to claim for the final semester of the senior year and you got the AOC and other limited credits the first four calendar years.

*ADDITIONALLY* if you do have any unforseen qualified expenses come up during that final senior semester and pay them out of pocket, then you would still qualify for the Lifetime Learning Credit. If paid with 529 funds, then the 529 distribution would just not be taxable is all.

[revenuecode]

I just discovered your follow-up to my question.  It's still not clear to me that just because 529 withdrawals must be matched with eligible expenses in a given year for those withdrawals to be non-taxable, that "matching" provides the answer to taxation of scholarship offsets.

The purpose of a withdrawal based on past scholarships is NOT to cover eligible expenses.  The purpose is to note that past eligible expenses that could have been covered using 529 withdrawals were instead covered by contemporaneous scholarship funds.  Perhaps one has to document that matching for a past tax year (or be prepared to document it), but a scholarship is a source of funds, not an expense.  If one at the end of college prudently did not liquidate 529 funds until college was paid for, there may never be future eligible education expenses (ignoring beneficiary changes, etc.).  The tax policy should not require withdrawing 529 money as scholarships are received in the same year, because it effectively penalizes scholarships:  the price of using a scholarship becomes not being able to continue saving current 529 funds that might be needed in the future (unless one is prepared to pay withdrawal penalties in future years despite the intent to waive penalties where scholarship money changes the need for 529 funds).

The only policy argument I see on the flip side is (i) multiyear documenting is burdensome to IRS for old scholarships and (ii) once a scholarship arrives, 529 money should not continue to be invested tax-free only to be withdrawn tax-free years later--either withdraw it when the scholarship is received as a one-year opportunity or lose the ability to have the scholarship recognized as the reason for "excess" 529 money.

As far as I can tell, after all these years, the IRS has intentionally not stated a clear position on this.

[Hal_Al]

You're preaching to the choir. Congress just missed an opportunity to correct this unfairness with the recent changes to 529 rules.

TurboTax will not give you an option, in the interview, to waive the penalty, because of the matching year criteria.

If you intend to claim it, you'll have to use the forms mode to override it. Forms mode is not available in the online editions.

Peter J. Greco, CPA, founder and chief tax strategist at the CSI Group, believes you have more latitude when deciding when to take the scholarship distribution. “Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense,” Greco says. “However, IRS 970 is silent as to when the money must be withdrawn. If Congress is trying to encourage 529 plans, then it makes good policy sense that the withdrawals can be made any time prior to graduation.” https://www.investopedia.com/news/penaltyfree-way-get-529-money-back/