Many parents assume that saving enough for college is the hard part. And to be fair, building a meaningful college fund over 15 or 20 years is no small accomplishment.
Once tuition bills begin arriving, parents can be faced with another challenge: deciding which dollars should pay for which expenses.
That becomes especially important when a student receives a scholarship and the family also has money in a 529 plan. Scholarships and 529 withdrawals can both provide valuable tax benefits, but they do not follow exactly the same rules.
In general, scholarship funds can be tax-free when used for tuition, as well as required fees, books, supplies, and equipment. But scholarship dollars used for room and board, travel, or other optional expenses may be taxable. The word “required” matters. Even a computer purchase may not qualify for tax-free scholarship treatment if the school does not require it.
529 plans can offer more flexibility. For a student enrolled at least half-time, 529 withdrawals can generally be used tax-free for qualified room-and-board expenses. They may also cover computers, software, and internet access used primarily for education, even when the school does not specifically require them.
That difference creates an opportunity for coordination.
Consider a student with:
- $12,000 of tuition and required fees
- $12,000 of room and board
- A $12,000 scholarship
- At least $12,000 available in a 529 plan
In the first scenario, the family applies the scholarship to tuition and uses the 529 plan for room and board. Assuming the expenses otherwise meet the applicable requirements, both sources can remain tax-free.
Now reverse the payments. The family uses the 529 plan for tuition and applies the scholarship to room and board.
The 529 withdrawal may still be tax-free, but the $12,000 scholarship used for room and board may become taxable income. At an assumed combined federal and state tax rate of 27%, that could create a tax bill of approximately:
$12,000 × 27% = $3,240
The family had the same college expenses, used the same resources to cover them, but came away with very different tax bills. The difference was simply how the payments were coordinated.
The tax planning may become even more nuanced when education credits are available. For families who qualify, the American Opportunity Tax Credit can be worth up to $2,500 per student. In certain situations, it may be beneficial to preserve some tuition expenses for the credit, even if doing so causes a portion of a scholarship to become taxable. The objective is not necessarily to make every individual dollar tax-free. It is to produce the best overall result.
Families should also be careful not to rely solely on Form 1098-T. The form may report tuition payments and scholarship amounts, but it does not always show whether part of the scholarship was taxable or include every award from outside organizations. Families should maintain records showing which funds paid each expense.
Saving for college is an accumulation problem. Paying for college is a coordination problem.
At Hanover Advisors, we help families look beyond the account balance and determine how 529 savings, scholarships, tax credits, and cash flow can work together. Before taking your next 529 withdrawal, consider reviewing the full funding strategy so that a well-earned scholarship does not create an avoidable tax bill.