What is the penalty on an unused 529 plan?

By: Savingforcollege.com | 
Updated:  August 29th, 2018

Only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty

  • Distributions are allocated between principal and earnings on a pro-rata basis.
  • That means that your withdrawal is divided into contribution and earnings based on the following formula:
    • Account Contributions / Account Value x Distribution = Contribution Portion.
  • Your contributions (the amount you originally deposited) will never incur penalty.

What are the exceptions to the penalty rule?

  • If the beneficiary dies or becomes disabled
  • If the student decides to attend a US Military Academy
  • If the student receives a scholarship
  • If the student receives educational assistance through a qualifying employer program
  • In all of these cases the earnings portion of the withdrawal will incur income tax.

Earnings will also be subject to tax as ordinary income at your tax rate

  • Non-qualified withdrawals will transform your 529 plan into a taxable investment.
  • However, some 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a low tax bracket.
  • In addition, if you were able to deduct your original contributions on your state income tax return, you will generally have to report additional state "recapture" income.

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So what is a non-qualified withdrawal?

  • Qualified withdrawals include
    • Tuition and fees
    • Books
    • Computers technology, related equipment and internet access
    • Special needs equipment
    • Some room and board expenses
    • Up to $10,000 in tuition expenses at private, public or religious elementary and secondary schools (per year, per beneficiary)
  • Non-qualified withdrawals include:
    • Transportation costs
    • Student loan repayments

What if I have excess funds? How do I minimize the penalty?

  • Change the beneficiary to another qualifying family member who is planning go to college
  • Hold the funds in the account in case the beneficiary wants to attend grad school later
  • Make yourself the beneficiary and further your own education

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