If your student wins a scholarship, the IRS lets you pull money out of a 529 plan up to the scholarship amount without the usual 10% penalty, even if that withdrawal exceeds the student’s qualified education expenses. This is the 529 plan scholarship exception, and it exists so families aren’t punished for saving diligently when financial aid later arrives. One catch worth knowing up front: the exception waives the penalty only. The earnings portion of that withdrawal is still ordinary income to whoever receives the check.
What the Exception Actually Waives
A 529 distribution is fully tax-free when it pays qualified education expenses. A scholarship shrinks that pool of expenses, so any withdrawal above what’s left becomes “non-qualified.” Non-qualified distributions normally get hit twice on the earnings: ordinary income tax plus a 10% additional tax.1Office of the Law Revision Counsel. 26 U.S. Code 529 – Qualified Tuition Programs
Under IRC 529(c)(6), which borrows the penalty rules from section 530(d)(4), the 10% additional tax disappears when the non-qualified distribution doesn’t exceed the amount of tax-free educational assistance the student received.1Office of the Law Revision Counsel. 26 U.S. Code 529 – Qualified Tuition Programs The income tax on the earnings portion stays.
The numbers make the point. If 25% of your 529 balance is earnings and you take a $5,000 scholarship-related withdrawal, $1,250 is taxable income. No penalty, but the income tax bill is real. Families who assume “penalty-free” means “tax-free” get an unpleasant surprise at filing.
What Counts as Tax-Free Educational Assistance
The exception isn’t limited to awards labeled “scholarship.” The IRS treats several kinds of aid as tax-free educational assistance that unlocks the penalty waiver:2Internal Revenue Service. Publication 970, Tax Benefits for Education
- The tax-free portion of any scholarship or fellowship grant.
- Pell Grants and other federal or state need-based aid that doesn’t have to be repaid.
- Veterans’ education benefits, including GI Bill payments.
- Employer tuition assistance excluded from the employee’s income, up to $5,250 per year under an employer educational assistance program.3Office of the Law Revision Counsel. 26 U.S. Code 127 – Educational Assistance Programs
- Any other nontaxable payment received as educational assistance, other than gifts or inheritances.
Only the tax-free portion of each award counts. If part of a scholarship is taxable to the student (because it pays for something other than qualified education costs), that portion doesn’t reduce your qualified expenses and doesn’t need the exception.
Calculating Your Penalty-Free Amount
Three buckets, one formula. The IRS uses Adjusted Qualified Education Expenses (AQEE) to sort a distribution into fully tax-free, penalty-free but taxable, or fully non-qualified.2Internal Revenue Service. Publication 970, Tax Benefits for Education
Step One: Find Your AQEE
Take total qualified education expenses for the year and subtract all tax-free educational assistance. What’s left is your AQEE, the maximum you can withdraw completely tax-free. If a student has $22,000 in qualified expenses and receives a $6,000 scholarship, AQEE is $16,000.
Step Two: Identify the Penalty-Free Window
The scholarship amount sets the ceiling for penalty-free withdrawals above the AQEE. In the same example, you can withdraw an additional $6,000, up to $22,000 total, without the 10% penalty. The earnings inside that $6,000 are taxable, but the penalty is waived. Anything beyond $22,000 is fully non-qualified: income tax and 10% penalty on the earnings, no exception available.
Step Three: Figure the Earnings Portion
The IRS allocates every withdrawal proportionally between contributions (basis) and investment growth (earnings). Say the account holds $44,000, split $33,000 contributions and $11,000 earnings. The earnings ratio is 25%. On a $22,000 withdrawal, $16,000 matches AQEE and its allocated $4,000 in earnings comes out tax-free. The remaining $6,000 falls under the scholarship exception. Its $1,500 in earnings is taxable as ordinary income but exempt from the 10% penalty.
Who Reports the Taxable Earnings
The person listed as the recipient on Form 1099-Q is the one who owes tax on any taxable earnings, and that depends on how the distribution was routed.4Internal Revenue Service. Instructions for Form 1099-Q (04/2025) If the money goes directly to the student or to the school on the student’s behalf, the beneficiary gets the 1099-Q and reports the income. If it goes to the account owner, the owner gets the form and owes the tax.
For scholarship-related withdrawals, where you already know some earnings will be taxable, directing the distribution to the student often results in a lower tax rate. Students with little other income sit in a lower bracket than a working parent, and the tax bill on that $1,500 of earnings from the example above can drop meaningfully as a result.
Filing the Paperwork
The plan administrator sends Form 1099-Q by January 31 of the year after the distribution. Box 1 shows the total, Box 2 the earnings, and Box 3 the basis.4Internal Revenue Service. Instructions for Form 1099-Q (04/2025) The form says nothing about scholarships or qualified expenses, so on its face the entire earnings figure looks taxable and penalized. The recipient has to reconcile the numbers on the return.
Taxable earnings, calculated with the AQEE formula from Publication 970, go on Schedule 1 of Form 1040, line 8z.2Internal Revenue Service. Publication 970, Tax Benefits for Education To claim the scholarship penalty waiver, file Form 5329, Part II. Line 5 reports the taxable distribution amount, and line 6 is where you enter the portion exempt from the 10% penalty, including amounts attributable to scholarships.5Internal Revenue Service. 2025 Instructions for Form 5329
Keep records. The 1099-Q, the scholarship award letter, tuition invoices, and receipts for books and required equipment should stay in a file. If the IRS asks, you need to prove the exact amount of tax-free aid and how you arrived at qualified expenses.
Other Ways to Handle a Scholarship Windfall
Pulling money out under the scholarship exception isn’t the only option when a scholarship shrinks the need for 529 funds. Two moves keep the money working and avoid income tax entirely.
Change the Beneficiary
You can switch the designated beneficiary to another family member with no tax consequences and no distribution reported. The IRS defines “family member” broadly: siblings, parents, children, stepchildren, in-laws, first cousins, and their spouses all qualify.6Office of the Law Revision Counsel. 26 USC 529 Qualified Tuition Programs You can also roll funds into a different 529 plan for a qualifying family member, though only one such rollover is allowed per beneficiary within any 12-month period.7Internal Revenue Service. 529 Plans: Questions and Answers This works well when a younger sibling is on the way to college or when the family wants to hold the funds for a future grandchild.
Roll Over to a Roth IRA
Since 2024, the SECURE 2.0 Act allows tax-free rollovers from a 529 plan into a Roth IRA for the beneficiary, subject to several conditions:1Office of the Law Revision Counsel. 26 U.S. Code 529 – Qualified Tuition Programs
- The 529 account must have been maintained for the current beneficiary for at least 15 years.
- Only contributions (and their earnings) made more than five years before the rollover date are eligible.
- The rollover counts toward the beneficiary’s annual Roth IRA contribution limit, $7,500 in 2026 for individuals under 50, reduced by any other IRA contributions that year.8Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
- $35,000 total per beneficiary is the lifetime cap across all 529 plans.
- The transfer has to move directly between the 529 plan and the Roth IRA custodian.
The 15-year clock is the sticking point. An account opened when the child was a toddler works. One opened in middle school probably doesn’t. When the timeline fits, oversized education savings turn into retirement savings for the same person, which is a decent consolation.
State Taxes Can Still Bite
Federal rules are only half the picture. Most states that offer an income tax deduction or credit for 529 contributions will recapture that benefit when you take a non-qualified distribution, and that recapture often applies to scholarship-related withdrawals even though the federal penalty is waived. Some states also impose their own additional penalty on the earnings. Check your state’s specific rules before pulling money out under the scholarship exception. A distribution that costs nothing federally can still generate a state tax bill, especially after years of deducted contributions.