When it comes to financing higher education, 529 plans offer a tax-advantaged way to save for college costs. However, when 529 account holders use funds from these accounts for non-qualified expenses, the IRS imposes a penalty.
So, while there is no penalty for leaving leftover funds in a 529 plan after a student graduates or leaves college, you’ll face a 529 tax penalty and a withdrawal penalty if you use a 529 plan distribution on non-qualified expenses. You’ll have to pay income tax and a 529 withdrawal penalty of 10% on the earnings portion.
529 plan withdrawal penalty
The earnings portion of a non-qualified 529 distribution (529 distribution used to pay for non-qualified expenses) is subject to a 10% withdrawal penalty. California even imposes an additional 2.5% state income tax penalty on those earnings.
- 529 plan distributions are allocated between the earnings and contribution (basis) portions.
- The contribution portion will never be taxed or penalized since it was made with after-tax dollars.
- In many cases, the penalty on non-qualified 529 plan distributions is 1-3% of the distribution amount – no worse than investing in a taxable savings account or brokerage.
529 penalty example
Let’s say you have $7,000 in qualified expenses this year, but you withdrew $8,000. So this leaves you with $1,000 in non-qualified expenses. In addition, your earnings portion for this distribution was $1,000.
So, how much is your 529 penalty?
Here’s a basic formula you can use to calculate how much of the non-qualified expenses are subject to taxes and penalties:
Non-Taxable Part of Distribution = ((Qualified Expenses)/(Total Distribution)) x (Earnings Portion)
Let’s plug in some numbers:
$7,000 (qualified expenses)/$8,000 (total distribution)
0.875 x 1,000 (total earnings) = $875
So, you don’t have to pay tax on $875 of the $1,000 extra you took out. The remaining $125 is subject to income tax and the 10% withdrawal penalty.
529 plan tax-free withdrawal limits
There is no numeric limit for 529 plan withdrawals as long as the withdrawal amount is consistent with the cost of your qualified education expenses.
However, if you’re withdrawing money for students between K-12, the tax-free withdrawal limit is $10,000 per year.
Exceptions to the penalty for 529 plan withdrawal
Some scenarios warrant a waived 10% penalty for 529 plan withdrawals. However, the earnings portion of the distribution is still subject to income tax.
The 10% penalty may be waived if:
- A beneficiary dies or becomes disabled
- A beneficiary receives a tax-free scholarship
- A beneficiary receives educational assistance through a qualifying employer program
- A beneficiary attends a U.S. Military Academy
- The taxpayer used qualified education expenses to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC).
Starting in 2024, beneficiaries will have the option to roll over funds from a 529 plan to a Roth IRA without incurring penalties. Beneficiaries are allowed a lifetime maximum of $35,000 for rollovers from a 529 plan to a Roth IRA, with rollovers adhering to the annual contribution limits of the Roth IRA.
What is a non-qualified 529 plan distribution?
Non-qualified distributions refer to any portion of a 529 plan withdrawal not used to pay for qualified education expenses. To help ensure that you are using your educational savings account appropriately, the IRS has a specific list of qualified education expenses that you can pay for using funds from your 529 plan without incurring federal income tax. These expenses are directly related to higher education at an educational institution, which may include universities, colleges, trade schools, and other post-secondary educational institutions eligible to participate in a student aid program run by the U.S. Department of Education.
Qualified 529 plan expenses include:
- Tuition and fees
- Computers, software, related equipment, and internet access
- Special needs equipment
- Cost of attendance, which includes room and board if the student is enrolled at least half-time
- Up to $10,000 in K-12 tuition expenses (per year, per beneficiary)
- Up to $10,000 in student loan payments (lifetime limit)
- Costs of apprenticeship programs
You may also use 529 plan funds towards the beneficiary’s Lifetime Learning Credit. This credit, claimed on your federal tax return, can further lower your taxes.
Non-qualified 529 plan expenses include:
- College application and testing fees
- Transportation costs
- Health insurance
- Extracurricular activities
- Expenses used to generate federal education tax credits such as the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC)
- Any expense that is not considered a qualified education expense
Non-qualified 529 plan distributions are taxable
The earnings portion of non-qualified distributions is subject to federal and sometimes state income tax.
- Non-qualified distributions payable to the beneficiary (student) are taxed at the beneficiary’s tax rate.
- Non-qualified distributions payable to the parent may result in a higher tax liability.
Any state income tax deductions or credits claimed may be subject to recapture in the event of a non-qualified distribution.
Recapture of state income tax benefits
The state might view the recapture of income tax benefits as an additional penalty.
Most states recapture previous state income tax deductions or tax credits on 529 plan contributions when the account owner makes a non-qualified distribution.
But, the state income tax deduction was a bonus available on 529 plans that is not available on other investments. You’re no worse off than if you were to have invested in a taxable account.
How to avoid paying taxes and penalties on leftover 529 plan funds
Avoiding the 529 plan penalty and income tax obligation on leftover funds is possible. Consider one of the following courses of action:
- Change the beneficiary to another qualifying family member who is planning to go to college
- Save the funds to pay for the beneficiary’s graduate school
- Make yourself the beneficiary and further your education
- Save the funds for a future grandchild
529 plans are excellent ways to save for your or your child’s college education. However, non-qualified withdrawals could impact your financial aid eligibility. When determining aid eligibility, the FAFSA considers a student’s income and assets, and it could include non-qualified 529 plan distributions in this calculation.
Understanding the rules around qualified expenses for 529 plans can help you maximize your education savings and avoid potential tax penalties. Always consider your current enrollment status, academic year, and eligibility for financial aid when planning your withdrawals.
If you’re uncertain about the eligibility of an expense, consult a tax advisor or refer to guidance provided by the IRS or FDIC. These entities provide FAQs and other resources to help you navigate the complexities of personal finance related to education savings.