Scholarships vs. 529 Plans: Maximizing Educational Savings

Planning for higher education expenses can be a daunting task for families. Scholarships and 529 plans are two popular tools to help ease the financial burden. Scholarships provide "free" money for college that doesn't need to be repaid, while 529 plans are tax-advantaged savings plans designed for future education costs. Understanding how these two options work, and how they can be used together, is crucial for effective college savings.

Understanding Scholarships

Scholarships are a great source of "free" money for college, unlike student loans, they don’t have to be repaid. Scholarships typically come from philanthropists, the government, corporations, or colleges or universities.

Types of Scholarships

The types of scholarships available are diverse:

Need-based scholarships: Awarded based on a student's financial need.
Merit-based scholarships: These are awarded based on individual talent, skill, academic merit, or athletic achievement.
Combination need- and merit-based scholarships: Awarded based on a combination of both.

Many scholarships are available for current college students to apply-and reapply-for each year.

Finding Scholarships

Deadlines typically fall between October and March, so students should start applying around the beginning of the school year, if not sooner.

A good place to start a scholarship search is with a high school guidance counselor, who has access to information to help guide the investigation of available scholarships. If a student has been involved in any sports, academic clubs, academic honors, or has done volunteer and community service, check with those organizations for additional scholarship opportunities. Local libraries might also have reference material to assist in a student’s search.

There are many free online scholarship search sites like Sallie Mae, FinAid, SmartScholar, and FastWeb. On these sites, students create a profile with their academic scores; community and volunteer service; and athletic, academic or other extracurricular activities. After supplying that information, students will be matched with scholarship applications for which they are eligible.

Sallie Mae also offers the Paying For College Resource, which even shows how to understand financial aid letters, once they are received. Once a child fills in the online form, the site will match them to over 1.5 million scholarships in Ohio’s database.

The Ohio Department of Higher Education (ODHE) can connect students to multiple scholarships and grants available throughout the state. Some scholarships are specifically given to a local student in someone’s memory with similar education plans. Local businesses may also offer scholarships for students who want to pursue a specific area of study or a certain vocation or technical skill. Local civic organizations, like Kiwanis and Rotary, offer scholarships. Finally, remember to check if the business where a student works or any organization at which they volunteer offers scholarships.

The Reality of Full-Ride Scholarships

One of the most frequently asked questions for Ohio 529 CollegeAdvantage is, “What happens with my 529 if my child receives a full ride?” While everyone hopes their child earns that amazing academic or athletic achievement, research shows that the odds are not in their favor. According to the NSCA College Recruiting (NCSA), only 1% of high school student-athletes receive some form of athletic scholarship at the Division I or II level. Moreover, even less are full-ride scholarships. Full-ride merit-based academic scholarships are just as rare as athletic ones.

Read also: Camp Scholarships Guide

Most athletic scholarships only cover a portion of higher education expenses to attend the school. However, there is another strategy to consider when it comes to scholarships: Apply for many smaller ones which could add up to cover a large portion of college, vocational, professional, or higher education costs. In fact, Sallie Mae’s 2024 “How America Pays For College” report shows that 27% of higher education costs are now covered by scholarships and grants.

Understanding 529 Plans

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. Contributions grow tax-free and withdrawals used for qualified education expenses are also tax-free.

Contribution Limits and Tax Benefits

In 2025, you can save up to $19,000 per parent in a 529 account, or $38,000 per couple. One set of grandparents can also contribute up to $38,000 as a couple per beneficiary per year. Contributing more than $19,000 per beneficiary would need to be reported to the IRS as a gift. Withdrawals from 529 plans are not taxed at the federal level as long as you understand and follow all the rules for qualifying expenses.

Qualified Expenses

Money saved in a 529 plan can also be used to pay qualified expenses associated with college or other postsecondary training institutions. As of 2019, qualified expenses include tuition expenses for elementary, middle, and high schools (private, public, or religious).

To calculate these, add up tuition and fees, room and board, books and supplies, any school-related special services, and computer costs, and then deduct any costs already covered by tax-free educational assistance. You'll also need to deduct costs used to claim an American Opportunity Tax Credit or Lifetime Learning Credit.

Read also: Benefits of NSHSS Scholarships

While funds from a 529 account can be used to pay for expenses required for college, not all expenses qualify. If a child is planning to live off campus in housing not owned or operated by the college, expenses in excess of the school's estimates for room and board for attendance there cannot be claimed. So it's important to confirm room and board costs with the school's financial aid office in advance so you know what to expect.

Computers and related equipment and services are considered qualified expenses if they are used primarily by the beneficiary during any of the years that the beneficiary is enrolled at an eligible educational institution. It's important to make sure that items purchased are qualified expenses and to keep receipts of purchase. Be careful to avoid expenses that don't qualify-for example, equipment used primarily for amusement or entertainment doesn’t qualify. These and other lifestyle expenses, like insurance, sports expenses, health club dues, and travel and transportation costs, will have to be funded through other resources. Check with the school to find out exactly what's required so you can avoid accidentally taking a nonqualified distribution.

Managing Withdrawals

When you pay qualified education expenses from a 529 account, your withdrawals are federal-income-tax- and penalty-free.

Your 529 savings plan administrator will, in most cases, provide an annual statement that reports your contributions and earnings, including the amount you withdrew from the plan. But it's you, not your program provider, who is responsible for accurately reporting to the IRS. If your withdrawals are equal to or less than your qualified higher education expenses (QHEEs), then your withdrawals including all your earnings are tax-free. If your withdrawals are higher than your QHEE, then taxes, and potentially a penalty, will be due on earnings that exceed your qualified expenses.

It's important that withdrawals you take from your 529 savings account match the payment of qualifying expenses in the same tax year. You may choose to pay the school directly from your 529 account for ease in recordkeeping and matching distributions to school expenses. In this situation, make sure you are aware of school payment deadlines and the time required to transfer funds from the 529 account to the school. Or you may choose to move money from your 529 account to your bank or brokerage account. You can choose to pay bills first and then reimburse yourself from the 529 account, or you can pull money from the 529 account and then use it to pay bills from your bank or brokerage account. Keep in mind that you must submit your request for the cash within the same calendar year-not the same academic year-as you make the payment.

Another withdrawal option: You could have the money distributed from the 529 account to your child. If some of the money is used for nonqualified expenses, such as buying a car, there may be reportable earnings-which will go on your child's tax return. Any earnings are taxed at your child's lower tax bracket-unless the so-called "kiddie tax" applies. The kiddie tax requires certain children as old as 23 to pay tax on unearned income at their parents' marginal tax rate. Another reason to have the distribution sent to your child is that it may be possible to wipe out any resulting tax with an American Opportunity Tax Credit or Lifetime Learning Credit. Because of income limitations, you may not be eligible to claim these credits on your own return.

If you withdraw money for anything that doesn’t meet the qualified expense criteria, any part of the distribution that is made up of earnings on contributions will be taxed as ordinary income and could incur a 10% federal penalty. If a distribution from a 529 plan is later refunded by an eligible educational institution, a recontribution can be made to the 529 plan. The recontribution must be made no more than 60 days after the date of the refund.

Coordinating 529 Plans with Other Financial Aid

The federal government offers additional tax incentives to help ease the burden of some college expenses, but unfortunately, you won't be able to use a 529 account to cover those same expenses. If you do, the IRS will consider it double dipping, so you'll want to factor in whether you'll be claiming this tax credit when deciding how much to withdraw from your 529 account.

American Opportunity Tax Credit allows families of undergraduates to deduct the first $2,000 spent on qualified education expenses and 25% of the next $2,000. To qualify for the full credit in 2024, single parents must have a modified adjusted gross income of less than $90,000, or less than $180,000 if married and filing jointly.

Lifetime Learning Credit provides up to a $2,000 tax credit on the first $10,000 of college expenses so long as your modified adjusted gross income is less than $90,000 in 2024 for a single filer, or less than $180,000 if married and filing jointly.

If your child has more than one 529 savings account, such as an additional account through a grandparent, knowing which account to use first or how to take advantage of them concurrently could help. Also, if financial aid is in the picture, a distribution from a grandparent-owned 529 account may be considered income to the child on a future financial aid application, which could significantly affect aid. To avoid any problems, grandparents can take distributions from 529s as early as the spring of the student's sophomore year-right after the last tax year on the student's last undergraduate Free Application for Federal Student Aid (FAFSA), assuming the student finishes college within 4 years.

What Happens If There's Money Left Over?

With careful planning, you can avoid having money left over in your 529 account once your child graduates. But if funds remain, there are several options available. You can let the money sit in the account in anticipation of your child continuing on to graduate school or another post-secondary institution. You also have the ability to change beneficiaries without incurring tax consequences. Change the designated beneficiary to another member of the original beneficiary's family. Roll over funds from the 529 account to the 529 plan of one of your other children without penalty.

If the beneficiary gets a scholarship, there is a scholarship exception to the 10% penalty. You can take a nonqualified withdrawal from a 529 account up to the amount of a scholarship; although you will pay taxes on the earnings, you won't pay the additional 10% penalty that's imposed on a nonqualified withdrawal.

Financial Aid Eligibility

If you'll count on financial aid to supplement your college savings, you'll want to do what you can to improve your eligibility. While individual colleges may treat assets held in a 529 plan differently, in general these assets have a relatively small effect on federal financial aid eligibility. Because 529 plan assets are considered assets of the parent, they tend to have a small effect when the government calculates your financial aid eligibility, whereas accounts that are considered assets of the child, such as an UGMA or UTMA account, tend to have a greater effect on federal financial aid eligibility. If you're thinking of taking out loans that start incurring interest immediately, you may want to spend 529 funds first, deferring these loans until later.

How to Use Your 529 with Scholarships

If you’ve been saving for your child’s future college costs in a 529 plan, your account is made to work with scholarships. If the offered scholarship isn’t a full ride, your 529 plan can help pay for other costs. Tuition, room and board (if your student is enrolled at least half time academically), mandatory fees, books, supplies, computers and related equipment and services are 529-qualified higher education expenses. Room and board can also include rent for off-campus residency and non-taxable only groceries, provided these costs are equal or less than the room and board allowances at the accredited education institution. If a child wants to live off campus, check with the school to find out the allowance limit; the child’s off-campus residency and non-taxable food costs cannot exceed it. 529-qualified withdrawals are not subject to federal or state income taxes. As the account owner, make sure to retain all documents of your 529 plan expenses and withdrawals. You have the burden of proof for tax purposes.

Let’s say that the offered scholarship does cover all your student’s higher education expenses, then you can also hold onto the 529 account to use if your child decides to pursue dental, law, medical, or other graduate school options. You also have the option to transfer the 529 to another beneficiary who is related to your child - including siblings, stepsiblings, parents, stepparents, cousins, grandparents, nieces and nephews - to avoid tax penalties. If you are thinking about continuing your own higher education, you can make yourself the new beneficiary of the college savings account. Also, there are no time limits on when you must use the funds saved in a 529 plan so you can keep saving in it for your grandchildren’s future college costs.

Another alternative is to withdrawal the exact amount of the scholarship from the 529 plan. As a non-qualified withdrawal, the earnings portion of the withdrawal will be subject to federal and state taxes. Usually, a non-qualified withdrawal would also be subject to a 10% federal tax penalty. However, there are three exemptions for 529 plans, with one being for receiving a scholarship.

Dispelling Myths About 529 Plans and Scholarships

It’s a myth that you’ll lose your 529 plan if the child wins a scholarship. A 529 plan offers tax-free earnings and distributions as long as the money is used to pay for qualified education expenses. If you take a non-qualified withdrawal, you’ll incur income tax and a 10% penalty - but only on the earnings portion of the withdrawal. Since your contributions were made with after-tax money, they will never be taxed or penalized.

Generally, a withdrawal from a 529 plan that doesn’t cover eligible college costs is subject to a 10% penalty from the IRS. In the case of a scholarship, non-qualified withdrawals up to the amount of the tax-free scholarship can be taken out penalty-free, but you’ll have to pay income tax on the earnings. Did you know that scholarships are taxable?

Suppose you don’t want to pay taxes when you withdraw. You can change the account beneficiary to another qualifying family member as the account owner. A younger sibling would be the obvious choice, but you can change the beneficiary to a parent, grandparent, niece, or nephew without tax consequences.

Unlike other college savings vehicles, such as Coverdell Education Savings Accounts, there’s no time limit on 529 savings plans - which means you can let your savings grow in your account until you have a use for them. Your child who earned a scholarship may continue to graduate school and need help paying for it. In fact, according to the National Center for Education Statistics, the average student loan balance for those who earned a master’s degree from a private nonprofit university in 2019-20 was over $53,000. Another option is to use your savings to continue your education. 529 plans can be used to pay for courses at any eligible institution, including community colleges and vocational schools. Another option is funding a Roth IRA using funds from a 529 plan.

Strategic Coordination of Scholarships and 529 Plans

As high school graduation approaches, more papers arrive from your child’s chosen university, including one that says they received a scholarship! It’s easy. You’ve got several options for using the funds in your 529 plan account. Your 529 plan is still a vital component of your college-saving strategy even with the scholarship. First, few scholarships cover 100% of the costs of college; therefore, a 529 plan is perfect for filling in the gaps. Maybe the scholarship only covers the actual tuition. There are numerous qualified expenses for which you can use your savings, including: tuition, room and board, mandatory fees, books, and computer technology, related equipment, and/or related services for education.

You can transfer the 529 plan funds to another beneficiary. The new recipient must be a family member to the original beneficiary to avoid tax penalties. This would include siblings, stepsiblings, stepparents, cousins, grandparents, nieces and nephews. For example, you could hold onto the account for your grandchildren’s future college costs since there are no time limits for using 529 plans.

You can withdraw up to the same dollar amount as the scholarship from the 529 plan. This will be a non-qualified withdrawal but only the earnings portion will be subject to federal and state income taxes.

You can withdraw all the funds from the 529 plan account. If not used for qualified expenses, this will be considered a non-qualified withdrawal. Like a 401(k) or a traditional IRA retirement account, there is a penalty assessed if money drawn from the account is used for something other than its intended purpose. So, an additional 10% federal tax penalty will be imposed on the earnings portion of the withdrawal.

Scholarship Displacement and 529 Plans

Scholarship displacement occurs when an academic institution reduces a student's financial aid package because the student receives an external scholarship. Private scholarship providers play a pivotal role in supporting students' educational journeys. However, college students who receive private scholarships experience scholarship displacement, negating the benefit of external scholarships. 529 plans can be utilized strategically by scholarship providers to distribute funds in a way that minimizes displacement.

Strategies to Minimize Displacement

Direct Contributions to 529 Plans: Instead of disbursing scholarship funds directly to the educational institution, providers contribute directly to a student's 529 plan.
Matching Contributions: Providers implement matching programs through which they contribute to a student's 529 plan when the student or family also contributes.

Scholarship-specific 529 accounts is an emerging tactic among private scholarship providers to enhance the effectiveness of their awards and mitigate issues like scholarship displacement. 529 plans can be coordinated to distribute funds in stages, such as per semester or academic year. payments. To implement scholarship-specific 529 accounts, providers can collaborate with financial institutions that manage 529 plans.

Potential Drawbacks

While establishing dedicated 529 accounts can be beneficial, organizations must consider potential drawbacks, such as administrative complexities, compliance requirements, investment volatility and tax implications. Managing these accounts requires administrative oversight and compliance with state and federal regulations. accounts may limit flexibility for students who transfer schools or face unexpected changes in their educational paths. barriers to accessing funds. Moreover, the investment options within a 529 plan may be subject to market volatility, potentially affecting the value of the funds available to students. Establishing clear policies and educating recipients on 529 plan usage can help address these challenges.

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