Only the earnings portion of a non-qualified 529 plan distribution is subject to a 10% withdrawal penalty.
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 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)
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
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 to 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
