Scholarships and 529 Plans

I am under the impression that one can obtain a receipt for the value of the scholarship at the university and then transfer that amount of money out of a 529 plan and into the personal account of the student, paying taxes on just the capital gains at the student’s tax rate.

Is that correct and has anyone done that?

That would be interesting. I think you are allowed to spend it on education related expenses only. If your kid’s scholarship does not cover room, board, books, transportation to/from home, then I think you can use the 529 funds for that (after consulting your tax advisor). I also believe you can spend it to cover clothes for school, computer, backpacks and possibly some medical expenses while in school. If you cannot spend all the funds in allowable ways for undergrad, you can certainly save it for graduate school or even transfer it to another of your kid’s 529 plan. I may be in a similar situation depending on where my kid goes, so please let us know anything you find out.

You do not need to request a receipt. Your scholarship will be listed in the 1098 T form you receive from the school at tax time.

And yes, if you have excess money in a 529 due to a scholarship, you will owe the regular taxes, but not the additional 10% penalty tax.

See IRS Publication 970.

Thanks @AroundHere. I have read that this is an exception to the 529 penalty, i.e. if you have saved for college in a 529 fund and then the beneficiary gets a large scholarship you are allowed to remove the value of the scholarship from the fund paying taxes only on the gains and no 10% penalty. That is a huge advantage to the Alabama merit scholarships. For the same amount of money, a child could graduate from State Univ X with no debt, or Alabama with no debt and potentially thousands of dollars in her personal account.

I should have mentioned that the receipt for tuition is not for the IRS but for the custodian of the 529 account so that they will release the funds properly.