Can a 529 Help Someone With a Full-Tuition Scholarship?

Published on Monday, July 11, 2022

Imagine a student with a full tuition scholarship and enough grants and private scholarships to cover 100% of room and board expenses. You might think that a 529 can't help this student or their parents.

You'd be wrong.

Take a taxpayer who is a resident of New Mexico. Their federal AGI is between $96,000 and $210,000 and their state income tax rate is 4.9%. New Mexico is one of four states1 that allows tax payers to deduct the full amount of 529 contributions from their taxable income. The taxpayer does not currently have a 529.

In our example, the student is a rising freshman attending a college that has the following annual cost of attendance (COA) estimate:

  • Tuition: $6,304
  • Room and Board: $8,560 ($4,190 for housing, $4,370 for a meal plan)
  • Books and Supplies: $960

The total eligible education expenses is $15,824. We'll split this in half and take a look at only Fall 2022. We'll also add a $1,000 allowance for a computer, another 529-eligible expense, bring the total eligible education expenses for Fall 2022 to $8,912.

The student was awarded a full-tuition scholarship from the school. They also received additional grants and private scholarships that will cover all of the room, board and book expenses. Only the computer expense isn't covered.

Education Expenses

Here are the expense transactions for Fall 2022:

DateTransactionAmount
7/11st housing payment-423
7/11st meal plan payment-433
8/12nd housing payment-423
8/12nd meal plan payment-433
9/13rd housing payment-423
9/13rd meal plan payment-433
9/1Tuition Scholarship, credited to the student's university account+3,152
9/1Grants and Private Scholarships, credited to the student's university account+4,760
9/1Fall 2022 Tuition-3,152
9/1Books-480
9/1Computer-1,000
10/14th housing payment-423
10/14th meal plan payment-433
11/15th housing payment-423
11/15th meal plan payment-433
Net Total-1,000

529 Transactions

What if the taxpaper opens an account with New Mexico's direct-sold 529 plan, and invests in the Capital Preservation Portfolio, making the following transactions:

DateTransactionAmount
9/1Open 529 with:+2,229
9/3Withdraw to taxpayer:-2,228
10/1Contribution:+2,228
10/3Withdraw to taxpayer:-2,228
11/1Contribution:+2,228
11/3Withdraw to taxpayer:-2,228
12/1Contribution:+2,228
12/3Withdraw to taxpayer:-2,228
Final 529 Balance+1

At the end of 2022, the taxpayer will have:

  • $8,912 in total eligible education expenses. It doesn't matter if the expenses were paid for by scholarship, grants, or even loan money. They will still be reported as expenses on the student's 1098-T tuition statement.
  • $8,913 in total contributions to a New Mexico 529. They'll report this on New Mexico's personal income tax adjustment form (PIT-ADJ), reducing their 2022 state income tax by $437.
  • $8,912 in total withdrawals from the 529.

The taxpayer refrained from withdrawing the last $1 to avoid the account being closed and the hassle of reopening it in following years.

Filing 2022 Federal Taxes

The student will receive a tuition statement, form 1098-T, from the university. Box 1 will have $3,152 for tuition paid to the university. Box 5 will have $3,152 for the school's full tuition scholarship. The student will report the additional grant and scholarship money and will pay income tax on it. They may pay no federal tax if their annual income is below the standard deduction.

The room and board, books, and computer expenses aren't reported on any forms from the university. The taxpayer will need to keep receipts with their tax documentation.

Because the taxpayer paid themselves from the 529, they will receive form 1099-Q from the New Mexico 529 plan.Their total withdrawals was equal to their total education expenses, so they won't owe any penalty for excessive withdrawals. And because they kept the money in the account for such a short period of time, they won't have any taxable earnings.

The taxpayer won't qualify for the American Opportunity Tax Credit (AOTC) because all of the tuition expense was covered by scholarships.

Filing 2022 New Mexico State Taxes

When the taxpayer files their state taxes, they'll have no income to report from their 529 withdrawals. The student will pay state income tax on the scholarship and grant money that exceeded their tuition expenses.

To receive the income tax deduction for the 529 contributions, the taxpayer will report the contributions as a personal income tax adjustment on form PIT-ADJ. In 2021, it was line 14 on PIT-ADJ. Reporting the contribution will reduce their state tax bill by $437.

Total State Income Tax Savings

Because the academic year spans across two calendar years, the taxpayer was only eligible for half of the state income tax savings in 2022. However, in 2023, assuming the student attends two semesters (Winter 2023 and Fall 2023), the taxpayer could qualify for as much as $825 in 2023. You'd need to adjust that if

  • the tuition rates increase
  • the student spends less on room and board by living off campus
  • the student had more/less book or computer expenses

Conclusion

In our example, the taxpayer didn't need to use a 529. But by using one, they can save as much as $3,325 on their state income taxes. That seems worth the hassle of opening an account, making brief contributions and withdrawals, and doing the extra tax paperwork.

If you want to learn more about New Mexico's 529 plan, there's a brochure that outlines some of the benefits. And if you enjoy legalese, you can checkout the actual tax eduction law here. Lastly, you can read the plan description for the New Mexico 529 plan, here.


Footnotes

  1. [1]: The four states are: Colorado, New Mexico, South Carolina and West Virginia.