If you’re using a 529 plan to save for college or your student is receiving scholarships congrats! That’s a smart step toward reducing the cost of higher education. But here’s something many families don’t realize: the IRS plays a bigger role than you think in how those funds are taxed (or not taxed). 

Done right, a 529 plan can be a tax-advantaged powerhouse. Done wrong, and you could end up with unexpected taxes and penalties. Here’s how to keep more of your money and stay on the IRS’s good side.

First, What Is a 529 Plan? 

A 529 plan is a tax-advantaged savings account designed for education expenses. Here's how it works: 

•  Contributions grow tax-free
•  Withdrawals are tax-free as long as they’re used for qualified education expenses
   

This includes things like: 

•  Tuition & fees
•  Required books & supplies
•  Room and board (if enrolled at least half-time)
•  Computers, software, and even internet access (if required)

Bonus: 

529 funds can now be used for K-12 tuition (up to $10,000/year) and student loan repayment (up to $10,000 lifetime per beneficiary). 

How Scholarships Affect Your 529 Plan 

Here’s the part that trips people up: scholarships can change how you use 529 funds. 

If your student receives a scholarship that covers some of their costs, you might not need to withdraw as much from your 529 account. That’s great but what if you already planned to use those funds? 

Two options: 

1. Adjust your withdrawal: Only take out what’s needed after accounting for the scholarship.
    
2. Take a non-qualified withdrawal (equal to the scholarship amount):
    You’ll pay regular income tax on the earnings but no 10% penalty.
   

It’s a helpful exception, but you need to track everything carefully to prove it to the IRS if asked. 

Avoiding Costly Mistakes with the IRS 

529 plans are flexible, but they’re not totally risk-free. Common mistakes include: 

•  Withdrawing funds in a different tax year than the expenses occurred
•  Overdrawing for non-qualified expenses like travel or optional fees
•  Not coordinating with other tax benefits like the American Opportunity Tax Credit (AOTC) 

   Quick Tip: 

Double dipping isn’t allowed. You can’t use the same tuition dollar to justify both a 529 withdrawal and an education tax credit. Plan carefully! 

How to Report 529 Plan Activity on Your Taxes 

You’ll get a Form 1099-Q from the plan provider showing the total distribution.

•  The student (beneficiary) is usually the one listed on the form.
  
•  If withdrawals match qualified expenses, you won’t owe taxes but you may still need to show documentation if audited.
   

Keep detailed records of: 

•  What was paid
  
•  When it was paid
  
•  What was covered by scholarships vs. 529 funds & what you claimed on your tax return

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  The Bottom Line 

  529 plans and scholarships are powerful tools to pay for college but mixing them without understanding the tax rules can cost you. By planning ahead and keeping good records, you can take full advantage of the benefits without any surprises from the IRS. 

  Because saving for college should save you money, not cause you stress. 

  Pro Tip: 

  Have leftover 529 funds after graduation? You may be able to roll them into a Roth IRA for the student (starting in 2024), or use them for grad school, siblings, or even yourself. 

   

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    Terry Wheeler has a new course available called Tuition Tax Secrets. Terry goes far beyond the 529 plans to help your family pay for college using the smart techniques he is using himself to save on his tuition bill for 5 children. Find out more here: TuitionTaxSecrets.com