A 529 plan is a savings plan designed to help save money for college expenses. The two types of 529 plans are prepaid tuition plans and college savings plans. They share the same penalty for withdrawal of funds for anything other than qualified education expenses. In both cases, you will have to pay income taxes on the earnings that you withdraw as well as an additional 10-percent tax penalty.
You will not risk a penalty if you limit your 529 plan withdrawals to qualified education expenses. College savings plans, which are investment plans, allow you to use account funds to pay tuition, mandatory fees, room and board, and required equipment such as textbooks and computers. Prepaid tuition plans, which allow you to pay tuition and fees at locked-in rates, limit qualified education expenses to tuition and mandatory fees, though some plans offer a room-and-board option. Withdrawals for qualified education expenses not only don't carry a penalty, but they also are not subject to income taxes on the earnings.
Contributions vs. Earnings
The withdrawals of contributions to a 529 plan are never taxed, whether they are taken for qualified education expenses or not. The reason is that the withdrawal of contributions amounts simply to a return of the investment made in the 529 account, according to the IRS. Earnings, however, must be used for qualified education expenses, or they're taxed. The central advantage that 529 plans offer investors is the tax-free investment growth that your money enjoys in mutual funds. That advantage is lost with a non-qualified withdrawal.
Determining a possible tax charge involves adding up your 529 plan distributions for the year and comparing them to your adjusted qualified education expenses for the year. Adjusted expenses means reducing tax-free educational assistance, such as Pell Grants or tax-free scholarships and fellowships, from overall expenses. If 529 plan distributions are greater than the adjusted qualified education expenses, any portion of that excess that comes from earnings will be taxed. Your 529 plan provider will send you a form 1099-Q, which shows how much of a 529 withdrawal comes from earnings. The beneficiary of the 529 plan typically is responsible for tax obligations.
In a few rare instances, withdrawals for non-qualified expenses do not draw a 10-percent tax penalty, though you still must pay income taxes on any earnings. For instance, the penalty does not apply if the funds are paid to the estate of the plan beneficiary after the death of the beneficiary or if money is distributed to a beneficiary who is disabled. It also does not apply if earnings from the withdrawal are subject to tax because the beneficiary received a tax-free scholarship, veterans' assistance or employer-provided educational assistance. In addition, the penalty does not apply if the beneficiary attends a federal military academy.
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