Withdrawing penalty-free from 529 when student received scholarships

[anonymouse1]

We've always just claimed qualified expenses (less those counted against the AOTC) after scholarships for withdrawals from 529s for both kids.  Now the youngest is entering her senior year and it looks like there will be money left in the 529(s) after graduation.  I'm wondering if this year we can claim the entire tuition and fees paid in spring and fall, including the $8000 that were paid by scholarships.  I understand that the $8000 would be taxable (to the student, if the student is the recipient?) but there would be no penalty.  The 529 plan FAQ says to "get a scholarship receipt" but the scholarships are listed on the statements each semester.

So what proof is required for the amount of the scholarships in 2025 to be withdrawn penalty-free?  If the student claims the scholarships as income, and DOESN'T take a withdrawal for the fall scholarship (which is being applied to the tuition, since she will be in off-campus housing), will she be able to count that $4000 toward the AOTC?  I believe that with her summer job and $8000 in scholarship income, her AGI will be more than the standard deduction so she will get some benefit from the AOTC (our income is too high to claim it).  Or is she better off taking both scholarships ($4000/semester in 2025) from the 529 and we'll claim her as a dependent on our taxes (meaning we'll get a $500 credit) though does that mean that the taxes on the "unqualified" (?) scholarship distribution will be taxed at our rate?

Also, since we have not been taking the amount of the scholarships out of the 529 all along, can we go back after graduation, and after paying off student loans, and close out the account without penalties by claiming scholarships awarded in 2024 and prior years?  Or does the equivalent amount received in scholarships need to be withdrawn from a 529 each calendar year like qualified expenses are?

[Hal_Al]

Q.  I'm wondering if this year we can claim the entire tuition and fees paid in spring and fall, including the $8000 that were paid by scholarships?

A. Yes. You may count payments made in and for the current tax year and for the 1st term of the following year. You may count tuition paid by scholarship, if the student claims the scholarship as income. 

Q. I understand that the $8000 would be taxable, to the student, if the student is the recipient?

A. Any taxable scholarship is taxable to the student (never to the parent) regardless of who is recipient of the 529 distribution is. 

Q. But there would be no penalty, for the 529 distribution?

A.  Yes, that's correct.  But there is no penalty on the $8000 distribution, whether or not the scholarship is taxable. By making the scholarship taxable, you avoid the tax on that much of the distribution (actually only the earnings portion of the $8000 is taxable). 

Q. So what proof is required for the amount of the scholarships in 2025 to be withdrawn penalty-free?

A. None, at tax filing time. If you are "audited", the statements and 1098-T is all the proof you need.

Q. If the student claims the scholarships as income, and DOESN'T take a 529 withdrawal for the fall scholarship (which is being applied to the tuition, since she will be in off-campus housing), will she be able to count that $4000 toward the AOTC?

A. Yes. But, as you appear to already know, only for non refundable portion of the AOTC*.  This is still worth up to $2500  because the AOTC shifts to all non refundable.

Q.  Or is she better off taking both scholarship amounts ($4000/semester in 2025) from the 529 and we'll claim her as a dependent on our taxes (meaning we'll get a $500 credit) though does that mean that the taxes on the "unqualified" 529 distribution will be taxed at our rate?

A. Yes, a non-qualified distribution is subject to tax at the parent rate ("kiddie tax").  Which way is better depends on the numbers (% of distribution that is earnings, how much AOTC student will get,  amount and type of income student has**).  Yes, it's usually better to make the scholarship taxable, particularly if AOTC is allowed. 

Q. Can we go back after graduation, and after paying off student loans, and close out the account without penalties by claiming scholarships awarded in 2024 and prior years?  Or does the equivalent amount received in scholarships need to be withdrawn from a 529 each calendar year like qualified expenses are?

A. Simple answer: Yes, you can claim the scholarship penalty exception, after graduation. That said, be advised there's some disagreement on the subject. Pub 970 doesn't  really say, but a conservative interpretation is that  the distribution must be made in the same year that the scholarship paid for the tuition expense.*** 

*While technically there is a provision that allows your student-dependent to claim a federal tuition credit, from a practical matter it seldom works out.  A full time student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he/she supports himself by working. She cannot be supporting herself on student loans & grants and 529 plans and parental support.  It is usually best if the parent claims that credit.  
If the student actually has a tax liability, there is a provision to allow him to claim a non-refundable tuition credit. But then the parent must forgo claiming the student as a dependent, and the $500 other dependent credit.  The student must still indicate that he can be claimed as a dependent, on his return. This is worth up to $2500 (AOTC shifts to all non refundable).

**Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024, $15,750 in 2025) and the dependent standard deduction calculation (earned income + $450).  It is not earned income for the kiddie tax and other purposes (e.g. EIC).  For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.

Taxable scholarship goes on line 8r of Schedule 1, from which TT treats it as hybrid income.

*** References: 

https://www.forbes.com/sites/josephhurley/2016/02/04/dont-make-these-mistakes-when-reporting-529-pla...  This one says you can claim the exception anytime, after graduation

529 Scholarship exception year 529 year. 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/

https://ttlc.intuit.com/community/college-education/discussion/re-529-plan-scholarship-refunded-late...

[NCperson]

@anonymouse1 on this one, the determination of whether the child is subject to Kiddie Tax has nothing to do with whether the child is claimed as a dependent. 

<<Q.  Or is she better off taking both scholarship amounts ($4000/semester in 2025) from the 529 and we'll claim her as a dependent on our taxes (meaning we'll get a $500 credit) though does that mean that the taxes on the "unqualified" 529 distribution will be taxed at our rate?>>

Please read the section "tax for certain children who have unearned income". Whether the parent decides to claim or not claim the child as a dependent (which is the parent's right), it doesn't change whether the child is subject to Kiddie Tax.  

https://www.irs.gov/taxtopics/tc553

Kiddie Tax Rules: 

1. The child's unearned income was more than $2,600.
2. The child meets one of the following age requirements:
   • The child was under age 18 at the end of the tax year,
   • The child was age 18 at the end of the tax year and didn't have earned income that was more than half of the child's support, or
   • The child was a full-time student at least age 19 and under age 24 at the end of the tax year and the child didn't have earned income that was more than half of the child's support.
3. At least one of the child's parents was alive at the end of the tax year.
4. The child is required to file a tax return for the tax year.
5. The child does not file a joint return for the tax year.

[anonymouse1]

We could claim her as a dependent in 2025 since we paid her spring tuition, room and board, if we pay for fall.  She's been paying her own living expenses over the summer - and could pay for the fall tuition (after the scholarship) and rent out of the 529 fund.  We're trying to figure out if she could claim the fall scholarship as income (perhaps both fall and spring), and the fall tuition that is being paid for by the (coincidentally) $4000 scholarship toward the AOTC.  If she includes $8000 of scholarships in 2025 as income, then her AGI should be over $16000.  If she pays her fall rent and groceries out of the 529, could she claim she is NOT eligible to be claimed as a dependent (since we only paid for spring expenses and she's been paying her own expenses all summer)?  With a gross income of say $16,000, and the new standard deduction of $15750, would there be any benefit to her claiming the AOTC (would she get any refund beyond what has been withheld from her paycheck?  I thought part of the AOTC was refundable?)?  We cannot claim the AOTC for 2025, but if we pay her fall support we could claim the $500 dependent credit.  Our income is too high to claim the AOTC.

Since we are hoping she will find a fulltime job after graduation and will be providing more than half her own support in 2026, we are counting on her claiming the AOTC for next spring (especially if she keeps the $4000/semester scholarship she's gotten since freshman year, and claims that as income and applies that to the qualified expenses for the AOTC, and pays the rest of the semester's expenses out of the 529).  So 2025 is the last year (we hope) we can claim her as a dependent.

[NCperson]

@anonymouse1 for 2026, you may be misunderstanding what "financial support" means. It's ALL the financial support provided to her during the ENTIRE year; it's not just from the day she finds a full time job until the end of the year.   The IRS has a formula for "support" - and it suprises most

I would encourage you to complete the worksheet on page 16 ....  Even if she finds a fulltime job in 2026 she may still not be providing 50% of her own support.  The value of YOUR home and the number of other dependents (i.e. her siblings) are some of the key drivers of how the IRS determines "support".   That same worksheet would also determine whether she is subject to kiddie tax, even with a full time job post graduation.   

Completing the form also creates defensible documentation that she is not subject to Kiddie Tax, should she ever be audited.

https://www.irs.gov/pub/irs-pdf/p501.pdf

if your income is too high to claim AOTC,  then your daughster could claim it if a) you do not claim her and b) her income exceeds $15750.  But since you could claim her and decide not to, as Hal_Al stated, the entire tax credit is non-refundable.  At $16,000 of income the tax is $25, so that is all the benefit of AOTC that she could muster.  

If you are not able to claim her as a dependent, then the benefit of AOTC to her with a full time job is much greater.   But again, even in the year of her graduation, she may still be eligible to be your dependent if she is under 24 years old and was a full-time student (i.e. went to school for at least 5 months of 2026).  

[anonymouse1]

OK, so the scholarships would be unearned income, and we definitely don't want to pay tax on that in our marginal tax bracket, and give up a $500 dependent credit, just so she could get an additional $25 from the AOTC.  So we'll claim her as a dependent this year and she won't claim the scholarships as income, and we won't claim the AOTC.

I'll look at the worksheet for 2026 - but even if she was a student for part of 5 months in 2026, I just assumed that if she found a fulltime job and moved to her own place shortly after graduation and was supporting herself for more than 6 months, and the last semester's expenses were paid out of her pocket, scholarship, and 529 with nothing coming from us, that she would not be considered a dependent, because we would have not been paying anything toward her support?

[anonymouse1]

Oops, taxable scholarships are considered earned income " Earned income (only for purposes of
filing requirements and the standard deduction)
also includes any part of a taxable scholarship."

[anonymouse1]

It says that in order to be a qualifying child, a student under 24 must also have lived with the person claiming him/her as a dependent for more than half the year (temporary absences such as for attending school count).  So If she found a job and moved out by June 30, she would not be a qualifying child.  She also would not be a qualifying relative if she earns more than $5050 in 2026.  Support doesn't even come into the equation unless the residency test is met.

But if she is out on her own by the end of June 2026, she could file her own taxes claiming that someone else CANNOT claim her as a dependent, and she can file for the AOTC even if she claims the $4000 scholarship in the spring as income and counts that toward the AOTC expenses (tuition) it was applied to, and pays for rent and groceries out of the 529 fund.  Then pays her own living expenses for the last 6 months of the year out of her earned income, which is the expectation for an adult working full time.