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.