Many parents establish 529 college savings accounts to cover some or all of their children’s college education costs. Distributions from a 529 account used for qualified education expenses are tax and penalty free if the amount distributed is equal to or less than the designated beneficiary’s (child’s) qualified education expenses during the same year.
For distributions that exceed the child’s qualified education expenses, the earning’s portion of the distribution may be subject to tax as well as an additional 10% penalty. One of the exceptions to this 10% penalty that is rarely discussed is scholarships.
This exception allows you to withdraw up to the amount of your child’s scholarships from the 529 account without paying the 10% penalty on the earnings, even if you don’t use the money for eligible college costs. To qualify for this exception it is suggested that you take the distribution in the same year the scholarship is received. You still have to pay taxes on the earnings withdrawn if they’re not used to pay for eligible college costs just no 10% penalty.
So if your child receives scholarships during his or her college years and you find yourself having excess monies in the 529 account as a result of the scholarships, you can withdraw it and use it for other purposes and avoid the 10% penalty.