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How to Avoid the 10% Tax Penalty on Non-Qualified Distributions

Written by Mark Kantrowitz | Updated July 9, 2020

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.

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About the author

Mark Kantrowitz is a nationally-recognized expert on student financial aid, scholarships and student loans. His mission is to deliver practical information, advice and tools to students and their families so they can make informed decisions about planning and paying for college. Mark writes extensively about student financial aid policy. He has testified before Congress and federal/state agencies about student aid on several occasions. Mark has been quoted in more than 10,000 newspaper and magazine articles. He has written for the New York Times, Wall Street Journal, Washington Post, Reuters, Huffington Post, U.S. News & World Report, Money Magazine, Bottom Line/Personal, Forbes, Newsweek and Time Magazine. He was named a Money Hero by Money Magazine. He is the author of five bestselling books about scholarships and financial aid, including How to Appeal for More College Financial Aid, Twisdoms about Paying for College, Filing the FAFSA and Secrets to Winning a Scholarship. Mark serves on the editorial board of the Journal of Student Financial Aid and the editorial advisory board of Bottom Line/Personal (a Boardroom, Inc. publication). He is also a member of the board of trustees of the Center for Excellence in Education. Mark previously served as a member of the board of directors of the National Scholarship Providers Association. Mark is currently Publisher of PrivateStudentLoans.guru, a web site that provides students with smart borrowing tips about private student loans. Mark has served previously as publisher of the Cappex.com, Edvisors, Fastweb and FinAid web sites. He has previously been employed at Just Research, the MIT Artificial Intelligence Laboratory, Bitstream Inc. and the Planning Research Corporation. Mark is President of Cerebly, Inc. (formerly MK Consulting, Inc.), a consulting firm focused on computer science, artificial intelligence, and statistical and policy analysis. Mark is ABD on a PhD in computer science from Carnegie Mellon University (CMU). He has Bachelor of Science degrees in mathematics and philosophy from MIT and a Master of Science degree in computer science from CMU. He is also an alumnus of the Research Science Institute program established by Admiral H. G. Rickover.

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