Why coordination matters

When a student receives both a scholarship and distributions from a 529 college savings plan, the interaction affects taxes, penalties, and financial aid. Done well, coordination reduces out‑of‑pocket costs and keeps withdrawals tax‑free. Done poorly, it can create avoidable income tax on earnings, trigger the 10% additional tax on nonqualified 529 distributions, or affect future aid eligibility.

This article explains the IRS rules and financial‑aid mechanics that matter most, offers practical timing and allocation strategies, and gives examples you can apply. It also links to deeper explainers on our site, such as our primer on 529 basics and a focused piece on 529s and financial aid tradeoffs.

Related reading: see our 529 Plans Explained: College Savings Basics and Coordinating 529s and Financial Aid: Tax‑College Tradeoffs for more on ownership and aid impacts.

Key rules you need to know (IRS and FAFSA)

  • Qualified expenses: 529 funds are tax‑free when used for qualified education expenses — tuition, fees, books, supplies and equipment required for enrollment, and (if enrolled at least half time) room and board, plus computer equipment and special needs services when required by the school (IRS Publication 970) (https://www.irs.gov/publications/p970).

  • Scholarship exception to the 10% penalty: If the student receives a tax‑free scholarship, you may withdraw up to the scholarship amount from a 529 plan without paying the 10% additional tax on earnings. However, any earnings allocable to that withdrawal are still subject to federal income tax (IRS Pub. 970).

  • FAFSA treatment: Ownership matters. A parent‑owned 529 is reported as a parental asset on the Free Application for Federal Student Aid (FAFSA) and generally has a smaller effect on aid eligibility (parent assets are assessed at a lower rate). A student‑owned 529 (or one owned by the student’s custodial account) is treated as a student asset and typically reduces aid eligibility more (StudentAid.gov).

Sources: IRS Publication 970 (Tax Benefits for Education) and Federal Student Aid (studentaid.gov).

Practical coordination strategies

1) Use scholarships for tuition first, when possible

  • Rationale: Many scholarships are designated for tuition and fees. When scholarship dollars cover tuition, you can preserve 529 dollars to pay other qualified costs (books, supplies, and room and board). Paying non‑tuition qualified expenses with 529 distributions keeps those withdrawals tax‑free and avoids having to rely on the scholarship exception that may trigger taxation of earnings.

2) If scholarship covers tuition you already paid with 529 funds

  • What to do: Don’t panic. The scholarship exception removes the 10% penalty for the portion of a 529 withdrawal equal to scholarship amount, but the earnings portion of that withdrawal remains taxable. To reduce taxes, consider reallocating future 529 withdrawals to non‑tuition qualified expenses or consult your plan administrator about redepositing a school refund (plan rules vary).

3) Match expenses to the lowest tax/aid cost outcome

  • Example: If a scholarship covers tuition only, prioritize using scholarship funds for tuition and 529 funds for room and board or required supplies. If a scholarship is unrestricted, decide whether applying it to tuition (freeing 529 for room and board) or to room and board (keeping 529 for tuition) yields the better tax and aid outcome — usually the first option is preferable.

4) Watch ownership and FAFSA timing

  • Timing matters for FAFSA: Assets are reported on the FAFSA snapshot date. If you change 529 ownership (some states allow beneficiary changes; rollovers between related beneficiaries are allowed), be aware of the application year you affect. Parent‑owned 529s generally reduce aid eligibility less than student assets (StudentAid.gov).

5) Keep excellent records and receipts

  • Always document what each payment covered: tuition invoices, housing charges, receipts for books/computers, and scholarship award letters that state any restrictions. For tax reporting, you must be able to show distributions match qualified expenses in the same tax year.

6) Think about refunds and redeposits

  • If the school issues a refund for tuition that was paid with a 529 distribution (because a scholarship arrived after payment), contact your 529 plan. Many plans permit redepositing refunds or reassigning funds; others require you to treat the refund as taxable or to roll it to another beneficiary. Policies differ — get written confirmation and document the transaction.

7) Consult a tax or financial aid professional

  • Small differences in timing, ownership, and whether funds are tagged to tuition vs. living expenses can change the tax outcome or your financial‑aid package. A planner or tax preparer who understands education benefits can save money.

Two worked examples

Example 1 — Scholarship covers tuition; save 529 for room and board

  • Situation: Tuition = $20,000. Student wins $10,000 scholarship restricted to tuition. Family has $25,000 in a 529.
  • Best move: Apply the $10,000 scholarship to tuition; use 529 funds for the remaining $10,000 tuition and $8,000 room/board. Because room/board is a qualified expense if the student is at least half time, those 529 withdrawals remain tax‑free.
  • Why: You avoid using the scholarship exception and keep withdrawals clearly qualified.

Example 2 — Scholarship arrives after you paid tuition with a 529

  • Situation: You used $20,000 from a 529 to pay tuition. After the term began, the student received a $10,000 scholarship that applies to tuition. The school refunds $10,000 to you.
  • Options: Return the refund to the 529 plan (if permitted) or earmark the 529 for other qualified expenses later. The scholarship exception avoids the 10% penalty on a withdrawal equal to the scholarship amount, but the earnings portion of that $10,000 is still taxable unless you recontributed the refund per plan rules.
  • Action: Talk to your plan administrator and tax advisor; document any redeposit or rollover.

Checklist to follow in the year of enrollment

  • Confirm scholarship terms in writing: Whether restricted to tuition, fees, or usable for room/board.
  • Map expenses: Estimate tuition, fees, books, supplies, and eligible room/board; decide which source pays which category.
  • Time your withdrawals: Align 529 withdrawals to match the tax year of the expenses they reimburse and keep receipts.
  • Check FAFSA timing: Know when assets are reported and how ownership affects aid.
  • Ask your plan about refunds and redeposits: Each plan has its own administrative rules.
  • If in doubt, consult an advisor before making large withdrawals or redeploying funds.

Common mistakes to avoid

  • Treating all 529 withdrawals as automatically tax‑free. (If used for nonqualified expenses, earnings become taxable and may incur a 10% penalty.)
  • Ignoring how ownership affects financial aid. (Parent‑owned 529s are generally better for need‑based aid calculations than student‑owned accounts.)
  • Failing to document expense timing and receipts. (You must show distributions matched qualified expenses in the correct tax year.)

When scholarships and 529s don’t play nicely

In some cases, scholarship awards change later or the school’s definition of room and board conflicts with what you planned. Institutional grants and merit scholarships may reduce an institution’s awarded need‑based aid. Private scholarships sometimes have strings attached. These situations require careful coordination with the financial aid office and your plan administrator.

Where to get authoritative answers

Further reading on our site:

Professional disclaimer

This article explains general rules and strategies and draws on professional experience advising families about education funding. It is educational only and is not individualized tax or financial advice. Rules and plan policies change — consult your 529 plan administrator, a tax professional, or financial aid officer for guidance tailored to your situation.