What is the penalty on an unused 529 plan?

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July 14, 2021

July 14, 2021

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.

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

A good place to start:

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