Each 529 plan distribution is made up of an earnings portion and a basis portion. The basis portion, or principal, consists of the contributions made to the account. Since 529 plan contributions are made with after-tax dollars, the basis portion of a 529 plan distribution will never be taxed or subject to penalty. However, you may not take a basis-only 529 plan withdrawal.
529 plan withdrawal rules
When funds are withdrawn from a 529 plan, the distribution is allocated pro rata between earnings and basis (contributions). If the distribution is used to pay for qualified education expenses, the entire amount of the distribution is tax-free. However, if the distribution is non-qualified, the earnings portion is subject to ordinary income tax and a 10% penalty.
The contribution portion is not subject to federal tax or penalty since 529 plan contributions are made with after-tax dollars. This is similar to how a Roth IRA works, however, unlike a Roth IRA, you must withdraw a portion of earnings with every 529 plan distribution. The basis portion and earnings portions are calculated using the following formula:
(Total Contributions / Value of 529 Plan Account) * Amount of Distribution = Basis Portion
Amount of Distribution – Basis Portion = Earnings Portion
The amount of the basis portion and earnings portion is listed on Form 1099-Q, which the 529 plan administrator sends to the recipient of the distribution. The recipient is typically the 529 plan account owner or the beneficiary, and they are responsible for paying any taxes associated with the distribution.
Qualified education expenses
529 plan distributions are tax-free when the funds are used to pay for most college expenses and up to $10,000 in K-12 tuition expenses per year. Qualified higher education expenses include:
- Tuition and fees
- Supplies and equipment
- Room and board, if the student is enrolled on at least a half time basis and is pursuing a degree or certificate program
- Computers and internet access
- Equipment required for a beneficiary with special needs
Costs of transportation and healthcare are not considered qualified expenses unless they are part of a comprehensive tuition fee, or the fee is identified as a fee that is “required for enrollment or attendance.”
Any expenses used to justify the American Opportunity Tax Credit or Lifetime Learning Credit must be subtracted from a beneficiary’s total amount of qualified education expenses. Double-dipping federal education tax benefits is not permitted and could result in a non-qualified withdrawal. However, the 10% penalty is waived if the non-qualified distribution is a result of double-dipping.
Exceptions to the penalty
In some cases, the 10% penalty on non-qualified distribution is waived, but the earnings portion of the distribution is still subject to ordinary income tax. These exceptions include:
- When the 529 plan beneficiary dies or becomes disabled
- When the beneficiary receives a tax-free scholarship
- When the beneficiary receives educational assistance through a qualifying employer program
- When the beneficiary attends a U.S. Military Academy
- The qualified education expenses were used to justify another federal education tax benefit, such as the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit
State tax rules
Some states do not conform to federal tax laws. For example, in some states:
- Distributions used to pay for K-12 tuition may be considered non-qualified expenses and subject to state income tax on the earnings portion of the distribution
- State income tax benefits may be subject to recapture in the event of a non-qualified distribution
- Outbound rollovers may be subject to state income tax and state tax recapture
- In California, if a non-qualified distribution is subject to the 10% penalty tax, the earnings portion of the distribution is also subject to a 2.5% California state tax
- In Alabama, only distributions from an Alabama 529 plan are exempt from Alabama state income tax