What Happens to 529 If Your Child Gets a Scholarship?

If your child gets a scholarship, the 529 plan is not stranded. Federal law lets you withdraw up to the scholarship amount without the usual 10 percent penalty on earnings, and the rest of the account keeps its options: spend it on other qualified education costs, change the beneficiary to another family member, or eventually roll leftover funds into a Roth IRA. So what happens to a 529 if your child gets a scholarship depends on which of those paths you choose, and the choices are not mutually exclusive.

One thing the waiver does not do is make the withdrawal free of income tax. Understanding that split — penalty gone, income tax on earnings still owed — is the starting point for every decision below.

The Scholarship Penalty Exception

A non-qualified 529 withdrawal normally triggers a 10 percent additional tax on the earnings portion of the distribution. When the beneficiary receives a scholarship, federal law removes that 10 percent penalty on withdrawals up to the dollar value of the scholarship.¹ A $15,000 scholarship unlocks up to $15,000 of penalty-free withdrawal. Take out more than the scholarship amount for non-qualified purposes and the 10 percent penalty applies to the earnings in the excess.

The exception is broader than academic merit awards. It also covers veterans’ educational assistance, employer-provided tuition benefits, and other tax-free educational payments, up to the amount of the benefit received.²

Income Tax You Still Owe

Your original contributions come back to you tax-free because you already paid income tax on them. Only the earnings — the investment growth — are taxable. The taxable share of any withdrawal is set by the ratio of earnings to total account value. If gains make up 25 percent of the account, 25 percent of the withdrawal is taxable income.

That income is taxed at the recipient’s regular federal rate, which runs from 10 percent to 37 percent for 2026 depending on total taxable income.³ Who “the recipient” is matters. If the plan sends the money directly to the student, the earnings land on the student’s tax return, often at a lower rate than the account owner’s.

Spend It on Costs the Scholarship Doesn’t Cover

Before pulling money out as taxable cash, look at what the scholarship leaves unpaid. Using 529 funds on qualified expenses skips both the penalty and the income tax on earnings, which is the best tax outcome available.

Qualified higher education expenses include tuition, fees, books, supplies, and required equipment. Computer hardware, software, and internet access qualify when the student uses them primarily for school. Special needs services connected to enrollment count too.¹

Room and board qualify if the student is enrolled at least half-time. Off-campus, the amount is capped at the school’s published cost-of-attendance figure for room and board. On-campus, you can use the greater of that figure or what the school actually charges.¹

Student Loans

If your child still ends up borrowing, you can use up to $10,000 from the 529 to pay down qualified education loans, covering principal and interest. That $10,000 is a lifetime cap per borrower, not an annual limit. The same cap applies separately to each sibling of the beneficiary, so a family with more than one child can put 529 money toward each child’s loans.¹

Apprenticeships and K-12 Tuition

Fees, books, supplies, and equipment for apprenticeship programs registered with the U.S. Department of Labor also qualify.⁴ And up to $10,000 per year can be used for tuition at a private, public, or religious elementary or secondary school, which can help if a younger sibling could use the funds.⁵

Coordinating With Education Tax Credits

Many families qualify for the American Opportunity Tax Credit or the Lifetime Learning Credit in the same year they take 529 distributions. You can claim one of these credits and take a tax-free 529 distribution in the same year, but the same dollar of expense cannot be used for both.² On a $20,000 tuition bill, you might set aside $4,000 to claim the American Opportunity Credit (worth up to $2,500) and cover the remaining $16,000 from the 529.

When you figure the tax-free portion of a 529 distribution, first reduce qualified expenses by the scholarship and any other tax-free educational aid, then reduce them again by the expenses you used to claim the credit.² Skipping that step turns part of an otherwise tax-free distribution into taxable income.

Changing the Beneficiary

If the scholarship recipient does not need the leftover money, you can move the account to another family member with no tax consequences. The IRS reads “member of the family” broadly: siblings, step-siblings, parents, children, first cousins, nieces, nephews, aunts, uncles, and the spouses of any of these relatives all qualify.¹ The account owner can even name themselves as the new beneficiary and use the funds for their own further education. Most plan administrators handle the change with a single form, and the funds keep growing tax-deferred in the meantime.

Rolling Leftover Funds Into a Roth IRA

Since 2024, unused 529 money can be rolled into a Roth IRA in the beneficiary’s name. Several conditions apply:⁶

The 529 account must have been open for more than 15 years.
Contributions made within the last five years, and their earnings, are not eligible to roll over.
The rollover in any year cannot exceed the annual Roth IRA contribution limit: $7,500 for 2026, or $8,600 if the beneficiary is 50 or older.⁷
Lifetime rollovers to a Roth IRA are capped at $35,000 per beneficiary.
The beneficiary must have earned income for the year at least equal to the rollover amount, and the Roth IRA must be in their name.

Because of the annual cap, moving the full $35,000 takes at least five years under current limits. No tax or penalty applies to the rollover itself when the rules are followed.

Watch Your State Taxes

The federal penalty waiver does not automatically extend to state taxes. Many states offer a deduction or credit for 529 contributions, and states differ on whether a scholarship-related withdrawal triggers recapture of that earlier break or state income tax on the earnings. Some states specifically exempt scholarship-based withdrawals from recapture; others do not. Check your state’s rules before you take the distribution.

Reporting and Records

After any distribution, the plan issues Form 1099-Q to whoever received the funds, showing gross distribution, earnings, and basis.⁸ If the money went directly to the student, the 1099-Q is issued under the student’s Social Security number and the student reports the taxable earnings.

To back up the scholarship penalty waiver, hold onto the official scholarship award letter showing the dollar amount and the academic period, along with proof of enrollment for that period and the 1099-Q. You do not file these with your return, but you will want them together if the IRS asks how the penalty-free withdrawal was calculated.

1
Office of the Law Revision Counsel. 26 USC 529 – Qualified Tuition Programs
2
Internal Revenue Service. Publication 970 Tax Benefits for Education
3
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
4
Internal Revenue Service. Topic No. 313, Qualified Tuition Programs (QTPs)
5
Internal Revenue Service. 529 Plans Questions and Answers
6
Internal Revenue Service. Publication 590-A (2025), Contributions to Individual Retirement Arrangements (IRAs) – Section: Can You Move Amounts Into a Roth IRA?
7
Internal Revenue Service. Retirement Topics – IRA Contribution Limits
8
Internal Revenue Service. Instructions for Form 1099-Q (Rev. April 2025)