There is no penalty for leaving leftover funds in a 529 plan after a student graduates or leaves college. However, the earnings portion of a non-qualified 529 plan distribution is subject to income tax and a 10% penalty.
529 plan withdrawal penalty
Only the earnings portion of a non-qualified 529 plan distribution is subject to a 10% withdrawal penalty. California imposes an additional 2.5% state income tax penalty on the earnings portion of non-qualified 529 plan distributions.
- 529 plan distributions are allocated between the earnings portion and the basis, which is the contribution portion
- The contribution portion will never be subject to tax or penalized since it was made with after-tax dollars
- In many cases, the penalty on non-qualified 529 plan distributions is no worse than investing in a taxable account
Exceptions to the 529 plan withdrawal penalty
In the following situations, the 10% penalty is waived for non-qualified 529 plan distributions, but the earnings portion of the distribution is subject to income tax:
- 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 qualified education expenses were used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC)
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 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
What is a non-qualified 529 plan distribution??
Non-qualified distributions refer to any portion of a 529 plan withdrawal that was not used to pay for qualified education expenses.
- Qualified 529 plan expenses include:
- Tuition and fees
- Books
- Computers technology, related equipment and internet access
- Special needs equipment
- 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)
- Student loan payments
- Costs of apprenticeship programs
- 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 AOTC or the LLTC
- Any expense that is not considered a qualified education expense
How to avoid paying taxes and penalty on leftover 529 plan funds
- Change the beneficiary to another qualifying family member who is planning go to college
- Save the funds to pay for the beneficiary’s graduate school
- Make yourself the beneficiary and further your own education
- Save the funds for a future grandchild
