What is the penalty on an unused 529 plan?

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