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Private scholarship providers may award scholarships as contributions to the recipient’s 529 college savings plan, instead of writing a check to the college or recipient.
Awarding scholarships by funding 529 plans offers several advantages:
Scholarship displacement advantage of 529 plans
Scholarship displacement occurs when receipt of a private scholarship leads to a reduction in other forms of financial aid. About a fifth of colleges reduce their own grants when a student wins a private scholarship, yielding no net financial benefit to the student. That is a dollar-for-dollar reduction in aid eligibility. Luckily, most other colleges reduce unmet need and student loans first when a student wins a private scholarship.
In addition, all or part of a scholarship may be reported as untaxed income on a subsequent year’s Free Application for Federal Student Aid (FAFSA). This causes the student’s eligibility for need-based financial aid to decrease by as much as half of the scholarship amount.
When a private scholarship is contributed to a 529 college savings plan that is owned by the student or the student’s parents, the scholarship is no longer considered to be “cash support.” Instead, the 529 plan is reported as a parent asset on the FAFSA. Parent assets reduce eligibility for need-based financial aid by as most 5.64% of the asset value.
Tax treatment advantage of 529 plans
If a student is a candidate for a degree and the scholarship is not payment for teaching, research or other services, only the portion of a scholarship, grant or fellowship that is used for tuition and required fees, books, supplies and equipment is tax-free. The rest is taxable. For example, the portion of a scholarship that is used to pay for housing, a meal plan, transportation and other living expenses represents taxable income to the student.
Contributing a private scholarship to a 529 plan expands the qualified higher education expenses to include more than just tuition, fees, books, supplies and equipment. In particular, amounts spent on room and board will also be tax-free, if the student is enrolled at least half-time. A 529 plan may also be used to pay for special needs services and for the cost of a computer, software, internet access and peripherals.
Tax-free growth of 529 plans
Contributions to a 529 college savings plan may grow on a tax-deferred basis. If the money is used to pay for qualified education expenses, the earnings are entirely tax-free.
Traditionally, a private scholarship is paid by check to the student or the student’s college or university. If the student is not yet enrolled in a college or university, the funds are deposited to an escrow account and released after the recipient provides proof of matriculation.
When a private scholarship is contributed to a 529 college savings plan, it is considered to be a completed gift of a present interest, yielding simpler accounting for the private scholarship provider.
Disadvantages of awarding scholarships through 529 plans
A key disadvantage of awarding a private scholarship through a contribution to a student or parent-owned 529 plan is a loss of control by the scholarship provider. The scholarship provider cannot ensure that the 529 plan funds are used to pay for college expenses. For example, nothing prevents the family from taking a non-qualified distribution from the 529 plan to buy a big-screen TV, other than the 10% tax penalty and ordinary income taxes on the earnings portion of the distribution. Also, if the 529 plan is owned by the parent, as opposed to a custodial 529 plan owned by the student, the parent could change the beneficiary from the student to a sibling or themselves.
However, these disadvantages are unlikely to be a problem in practice.
While the private scholarship provider has the option of serving as the account owner, this would have a negative impact on the student’s eligibility for need-based financial aid. When a 529 plan is owned by someone other than the student or the student’s parents, it is not reported as an asset on the FAFSA. However, distributions from such a 529 plan are treated as income to the student, reducing eligibility for need-based aid by as much as half the distribution amount.