A 529 plan is the frequently used name for a qualified tuition plan, a tax-advantaged plan designed to help save money for college expenses. Because 529 plans were created specifically for college costs, the tax code that governs the plans includes penalties for withdrawing earnings for reasons other than qualified higher educational expenses.
A core advantage to 529 plans is that the funds contained in them grow without incurring taxes. When it is time to withdraw the money to pay college expenses, no taxes are owed on the income that the funds provide. However, if you withdraw all or a portion of the earnings early, before college expenses arise, then you will have to pay ordinary income taxes on the earnings. In addition, you will have to pay a 10-percent tax penalty on the funds. Depending on the state where you enrolled in the 529 plan, you also may have to pay state income taxes on the earnings.
When you contribute money to a 529 plan, it is money that was already taxed. It did not come from pretax income, in contrast to funds in a financial vehicle such as a traditional IRA. This means that you can withdraw principal that you contributed to a 529 plan without having to pay either ordinary income taxes or the tax penalty. The tax consequences only apply to earnings. You would need to pay state taxes if you received a tax break from the state sponsor of the plan on your original contributions to the plan, according to SavingForCollege.com.
The tax regulations for 529 plans ensure that the person who benefits from an early withdrawal of account funds will be the person responsible for paying the tax bills that accompany the distribution. The person liable for the taxes, including both ordinary income taxes and the 10-percent tax penalty, is always either the account holder or the beneficiary of the account. It simply depends on who receives the money. If you own the account and take a distribution from it, then you must pay the taxes on it. If you withdraw the money to provide to the beneficiary, then it is her responsibility.
The IRS allows some special circumstances when the 10-percent tax penalty does not apply to early withdrawals or other withdrawals unrelated to college costs. However, ordinary income taxes still apply to those distributions. Most exceptions do not relate to early withdrawals, but two instances do. The tax penalty does not apply for early withdrawals made if the designated beneficiary dies or becomes severely disabled.