What is the penalty on an unused 529 plan?
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 US Military Academy
- If the student receives a scholarship
- If the student receives educational assistance through a qualifying employer program
- In all of these cases the earnings portion of the withdrawal will incur income tax.
Earnings will also 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
- Computers technology, related equipment and internet access
- Special needs equipment
- Some room and board expenses
- Up to $10,000 in tuition expenses at private, public or religious elementary and secondary schools (per year, per beneficiary)
- Non-qualified withdrawals include:
- Transportation costs
- Student loan repayments
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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