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A 529 plan is an investment account that you can use to save for a child’s college education or even your own. Tax-free growth on your investments and possibly getting a tax deduction or credit on your contributions make these education savings plans appealing.
But the 529 withdrawal penalty may make some people think twice about using these plans. Although there are some 529 withdrawal penalty exceptions, using your college savings plan funds for ineligible expenses can be costly.
529 plan withdrawal rules
Because a 529 plan offers tax breaks for education savings, the IRS has strict rules on how you can use the funds without incurring a penalty.
More specifically, if you want to avoid taxes and a penalty for withdrawing from a 529 plan for your college-aged student, you can use the money to cover only the following:
- Tuition and fees
- Room and board, if you’re attending at least half-time and pursuing a degree or certificate program
- Computer and internet access
- Equipment for a student with special needs
As long as the money is used for qualified education expenses for the college-aged student, there is no withdrawal limit for 529 plans.
Account holders can also use 529 plan funds to pay up to $10,000 per year in K-12 tuition expenses. You can typically make withdrawals from the account through your plan’s provider online, by phone or by mail.
In addition, the 2019 SECURE Act made it possible to use up to $10,000 from a 529 plan to pay off the beneficiary’s student loans and an additional $10,000 for the student loans of each of the beneficiary’s siblings.
What is the 529 plan withdrawal penalty?
If you don’t use your college savings plan for eligible expenses, your 529 plan nonqualified withdrawals may incur a 10 percent penalty and will also be subject to federal income taxes on the investment gains at whatever rate the IRS would normally charge. However, there’s no 529 early withdrawal penalty like there is with retirement accounts.
There are also state penalties for nonqualified withdrawals from 529 plans. Many states impose taxes on nonqualified withdrawals.
In Washington state, for example, the 529 withdrawal penalty for non-qualified distributions includes earnings on 529 funds being taxable at the federal and state level, plus the 10% federal penalty.
In Illinois, the penalty is even steeper. Any 529 earnings used for a non-qualified 529 withdrawal trigger federal and state income taxes plus the 10% federal penalty. Additionally, Illinois may attempt to take back previous tax deduction benefits.
No matter where you live, the penalty and any taxes imposed will apply only to your gains in the account. This is because the money you contributed was already taxed, so you’re getting tax-free growth only on what your investment earns.
Exceptions to the 529 withdrawal penalty
In general, you can’t escape income taxes on 529 plan nonqualified withdrawals. But there are some exceptions to the 10 percent penalty:
- The beneficiary of the plan has died or become disabled
- The beneficiary received a tax-free scholarship
- The beneficiary received educational assistance through a qualifying employer program
- The beneficiary is attending a U.S. military academy
- The funds are used to claim another educational tax benefit, such as the American opportunity tax credit, lifetime learning credit or tuition and fees deduction. Just be sure you know how to use these other educational benefits alongside your 529 plan.
When it comes to scholarships, educational assistance and military academy attendance, you can withdraw up to the amount of the scholarship benefit you or your child received from the 529 plan and avoid the 10 percent penalty.
You will, however, still have to pay taxes on the earnings portion of the withdrawal. Be sure to ask for a receipt or some sort of documentation of the scholarship you can use as proof at tax time.
Note that some states may have different rules than the federal government. For example, your state may consider withdrawals for K-12 tuition expenses to be a nonqualified distribution.
Your state may also reverse past deductions or credits that you received for contributions if you don’t use your 529 plans for qualified expenses or if you transfer the money to another state’s plan.
Consider consulting a tax professional before taking money from your 529 plan.
Other ways to use a 529 plan
If your child decides not to attend college or gets enough assistance through scholarships or an employer that they don’t need the money you’ve saved, don’t fret. There are other ways to still enjoy the benefits of tax-free withdrawals.
Help a family member pay for school
As the owner of the 529 plan, you’re allowed to change the beneficiary to someone else in your family without incurring any fees. So if one child doesn’t need the funds, you can switch your beneficiary to another family member of the original beneficiary.
Pay down student loan debt
The SECURE Act allows 529 plan owners to use up to $10,000 to pay off student loan debt without any tax consequences or penalties. The limit is based on the beneficiary, not the account, so you can use this approach with more than one beneficiary.
Pay for K-12 education
In most states, 529 plan owners can use funds to pay up to $10,000 per year in K-12 tuition expenses without penalty or tax burden. This can be especially helpful if you have children in private schools.
Pay for training program expenses that qualify
529 plan withdrawals don’t incur taxes or fees as long as your child is attending an eligible postsecondary institution, which includes trade schools. If your child wants to pursue another type of training program, check the IRS’ list of eligible educational institutions to see if you’re in the clear.
Pay for your own education
In addition to changing the beneficiary from child to child, you can also change it to yourself. If you plan to pursue a postsecondary degree or certificate of your own, you can use leftover 529 plan funds to cover your expenses without incurring a 529 withdrawal penalty.
The bottom line
You will incur a penalty for withdrawing money from a 529 college savings plan to use on nonqualified expenses but there are some exceptions to this rule.
Before tapping into the funds in your 529 account, research the penalty exemptions to determine whether your needs align with some of the exceptions. If the beneficiary received a tax-free scholarship or is attending a military academy, for instance, you may be able to avoid paying the penalty for using 529 money.