How to Use Excess 529 College-Savings Funds

If your child receives a scholarship, you can withdraw up to that amount from a 529 plan penalty-free.

By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance

Our son starts college in the fall, and we are thrilled that he won a full-tuition scholarship worth more than $40,000 per year. We now expect to pay less than $15,000 per year for room and board and books. How can we use the excess 529 money?

Congratulations to your son! Normally, you would owe income taxes and a 10% penalty on the earnings portion of 529 withdrawals that aren’t used for qualified education expenses. But there is an exception for tax-free scholarships: You can withdraw up to the amount of the scholarship without being subject to the 10% penalty (you will still have to pay ordinary income taxes on the earnings).

When taking a scholarship withdrawal, make sure the money [and the 1099 form reporting the withdrawal] is sent to the student, who is likely to be in a lower tax bracket than you,” advises Joe Hurley, founder of Savingforcollege.com. Most 529 plans give you the option of making withdrawals payable to the owner, the beneficiary or the school.

Also, look for other eligible expenses that will allow you to use 529 funds tax-free -- not only room and board and books, but also mandatory fees. If your son ends up going to graduate school, he can use the money for those expenses, too. Or you can switch the beneficiary of the 529 plan to another family member who plans to attend college.