The earnings portion of a non-qualified distribution from a 529 plan is subject to income tax at the beneficiary’s rate, plus a 10 percent tax penalty. There are, however, several exceptions in which the 10 percent tax penalty does not apply, such as death or disability of the beneficiary and receipt of a qualified scholarship by the beneficiary.
Exceptions to the 10 Percent Tax Penalty
A non-qualified distribution from a 529 college savings plan is not subject to the 10 percent tax penalty if the distribution was non-qualified because of certain circumstances or because of the receipt of certain other tax-free education benefits.
- Receipt of Education Tax Credits. A non-qualified distribution is exempt from the 10 percent tax penalty to the extent that the beneficiary’s qualified higher education expenses were reduced because of coordinating restrictions involving the receipt of the American Opportunity Tax Credit or Lifetime Learning Tax Credit in the same tax year.
- Receipt of Scholarships. A non-qualified distribution is exempt from the 10 percent tax penalty if the beneficiary received a qualified scholarship, veteran’s education benefits or other tax-free payment of educational expenses at a college or university that is eligible for Title IV federal student aid. Employer-paid education assistance is an example of the latter. The portion of the distribution that is exempt from the 10 percent tax penalty is limited to the amount of the scholarship, veterans education benefits and other tax-free payment of educational expenses.
- Attendance at a U.S. Military Service Academy. A non-qualified distribution is exempt from the 10 percent tax penalty if the beneficiary attended the U.S. Military Academy, the U.S. Naval Academy, the U.S. Air Force Academy, the U.S. Coast Guard Academy or the U.S. Merchant Marine Academy, to the extent that the distribution does not exceed the “costs of advanced education attributable to such attendance.”
- Death. A non-qualified distribution is exempt from the 10 percent tax penalty if the distribution is made to the beneficiary, to the estate of the beneficiary or to the beneficiary’s heirs on or after the death of the designated beneficiary.
- Disability. A non-qualified distribution is exempt from the 10 percent tax penalty if the distribution is made because the designated beneficiary is considered disabled. A beneficiary is considered to be disabled if he or she is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration” [26 USC 72(m)(7)]. The distribution must be attributable to the beneficiary’s disability.
- Return of Excess Distributions. The 10 percent tax penalty does not apply to the extent that a distribution is non-qualified because the beneficiary receives a refund from an eligible educational institution and the refund is recontributed to a 529 plan for the same beneficiary within 60 days, per 26 USC 529(c)(3)(D).
Must Scholarships Be Used in the Same Tax Year?
The IRS has not clarified whether the scholarships must be received in the same year as the non-qualified distribution.
The statutory language states that the 10 percent tax penalty does not apply if the non-qualified distribution is “made on account of a scholarship, allowance or payment … received by the designated beneficiary to the extent that the amount of the distribution does not exceed the amount of the scholarship, allowance or payment.” This implies that the distribution was non-qualified because the receipt of the scholarship caused a reduction in qualified higher education expenses. Accordingly, the waiver of the tax penalty because of a scholarship cannot be based on the receipt of a scholarship in a previous year.
There is some ambiguity, however, because the statutory language concerning the coordination restrictions for the education tax credits specifies that the reduction in qualified education expenses is “for the taxable year” while the exception for scholarships does not include similar language. One could argue that this does not preclude a scenario in which the taxpayer takes a non-qualified distribution corresponding to a qualified scholarship received in a previous tax year.