Is the 529 penalty waived if the student gets a scholarship?

Two separate taxes

A 529 withdrawal that is more than the student's adjusted qualified education expenses (AQEE) triggers two separate consequences. First, a share of the earnings is added to income. Second, Publication 970 says that if you receive a taxable distribution you must also pay a 10% additional tax on the amount included in income. A scholarship helps mainly with the second one. The first stays: the publication's scholarship exception waives the additional tax, not the income tax, on the earnings that become taxable because aid reduced your expenses.

The reason the scholarship creates the problem in the first place is that AQEE is total qualified expenses minus tax-free educational assistance. A student with $26,000 of costs and a $10,000 tax-free scholarship has AQEE of only $16,000. If the family has already taken $20,000 from the 529, $4,000 is more than the AQEE, and a corresponding share of the earnings is taxable.

The exception, in the publication's words

The 10% additional tax does not apply to a distribution included in income because the designated beneficiary received a tax-free scholarship or fellowship grant, veterans' educational assistance, employer-provided educational assistance, or any other nontaxable payment, other than a gift or inheritance, received as educational assistance. The publication adds that this exception applies only to the extent the distribution is not more than the scholarship, allowance or payment. Other exceptions on the same list cover distributions paid after the beneficiary's death, distributions made because the beneficiary is disabled, distributions made on account of attendance at a U.S. military academy up to the costs of advanced education, and amounts included in income only because the same qualified expenses were used to figure the American opportunity or lifetime learning credit.

Worked example

A student has $26,000 of qualified expenses, receives a $10,000 tax-free scholarship, and the family takes a $20,000 529 distribution that Form 1099-Q splits into $6,000 of earnings and $14,000 of basis. AQEE is $26,000 - $10,000 = $16,000. Tax-free earnings are $6,000 x $16,000 / $20,000 = $4,800, so $1,200 of earnings is taxable and goes on Schedule 1, line 8z. Without any exception the 10% additional tax would be $120. Because the taxable $1,200 arose from the scholarship, and the distribution is well within the $10,000 scholarship, the exception removes the $120. The $1,200 is still taxed at ordinary rates. The tool above runs this arithmetic, and caps the covered amount at the scholarship, as the publication describes.

For comparison, take the publication's own example of a student with $8,300 of expenses, a $3,100 tax-free partial scholarship and a $5,300 distribution including $950 of earnings. AQEE is $5,200, tax-free earnings are $932 and taxable earnings are $18.

Where to report

Report the taxable earnings on Schedule 1 (Form 1040), line 8z. Use Part II of Form 5329 to figure any additional tax, and the publication tells you to report any result on Schedule 2 (Form 1040), line 8. When an exception applies you enter the exception amount on Form 5329 so the additional tax is reduced; the form's instructions explain the entries. The publication also notes that qualifying amounts rolled over to another 529 or an ABLE account within 60 days are not taxable and are not reported anywhere on the return.

Keep the Form 1099-Q, the scholarship award letters and the school's statement of costs. If the aid arrives after you have already taken the distribution, you can sometimes avoid the problem: a student who receives a refund of qualified expenses that were treated as paid by a 529 distribution can recontribute the amount to a 529 plan within 60 days of the refund to avoid figuring the taxable part.

Sources

• IRS Publication 970, Tax Benefits for Education (2025): Chapter 7, Additional Tax on Taxable Distributions. Read November 2, 2026.

Edition read: Publication 970 (2025), for use in preparing 2025 returns. Dollar limits, income thresholds and dates in this publication are for tax year 2025; check the current publication and form instructions for the year you file. This page summarizes the publication and does not replace it.