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What is the penalty on an unused 529 plan?Updated: 2015-01-02

Only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty

  • Distributions are allocated between principal and earnings on a pro-rata basis.
  • That means that your withdrawal is divided into contribution and earnings based on the following formula:
  • Account Contributions / Account Value x Distribution = Contribution Portion.
  • Your contributions (the amount you originally deposited) will never incur penalty.

What are the exceptions to the penalty rule?

  • If the beneficiary dies or becomes disabled
  • If the student decides to attend a U.S. Military Academy
  • If the student receives a scholarship
  • In all of these cases the earnings portion of the withdrawal will incur income tax.

All earnings on non-qualified distributions will be subject to tax as ordinary income at your tax rate

  • Non-qualified withdrawals will transform your 529 plan into a taxable investment.
  • However, some 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a low tax bracket.
  • In addition, if you were able to deduct your original contributions on your state income tax return, you will generally have to report additional state "recapture" income.

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So what is a non-qualified withdrawal?

  • Qualified withdrawals include:
  • Tuition and fees
  • Books
  • Equipment required for course enrollment (including special needs equipment)
  • Some room and board expenses
  • Non-qualified withdrawals include:
  • Transportation costs
  • Computers (unless the school requires them)
  • Student loan repayments

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What if I have excess funds? How do I minimize the penalty?

  • Change the beneficiary to another qualifying family member who is planning go to college
  • Hold the funds in the account in case the beneficiary wants to attend grad school later
  • Make yourself the beneficiary and further your own education

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