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 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

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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.

How to avoid paying taxes and penalty on leftover 529 plan funds

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 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

A good place to start

See the best 529 plans, personalized for you

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.

How to avoid paying taxes and penalty on leftover 529 plan funds