What Is a 529 Plan Penalty and How to Avoid It 2023

529 Plan Penalty – A 529 plan is a tax-advantaged savings account that can help you save for your child’s education expenses, such as tuition, fees, books, and room and board. You can invest your money in a variety of options offered by your state’s 529 plan and enjoy tax-free growth and withdrawals as long as you use the money for qualified education expenses.

However, if you withdraw money from a 529 plan for non-qualified expenses, such as travel, entertainment, or personal use, you will have to pay taxes and penalties on the earnings portion of your withdrawal. This can reduce the value of your savings and discourage you from using your 529 plan for other purposes.

In this article, we will explain what is a 529 plan penalty, how it is calculated, and how you can avoid or minimize it.

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What Is a 529 Plan Penalty?

A 529 plan penalty is a 10% additional tax that applies to the earnings portion of a non-qualified withdrawal from a 529 plan. The earnings portion is the difference between the amount you withdraw and the amount you contributed to the plan. For example, if you withdraw $10,000 from your 529 plan and your contributions were $8,000, your earnings portion is $2,000.

How 529 Penalty is calculated

The 10% penalty is in addition to the regular income tax that you have to pay on the earnings portion of your withdrawal. Depending on your tax bracket and state tax laws, this can result in a significant tax bill. For example, if you are in the 24% federal tax bracket and withdraw $10,000 from your 529 plan with $2,000 of earnings, you will have to pay $480 in penalty ($2,000 x 10%) and $480 in federal income tax ($2,000 x 24%), for a total of $960 in taxes.

The penalty and taxes only apply to the earnings portion of your withdrawal. You do not have to pay any taxes or penalties on the contributions portion of your withdrawal, as this is money that you already paid taxes on when you earned it.

How to Avoid or Minimize a 529 Plan Penalty

There are several ways to avoid or minimize a 529 plan penalty if you need to withdraw money from your account for non-qualified expenses. Here are some of them:

Use the money for qualified education expenses

The best way to avoid a 529 plan penalty is to use the money for qualified education expenses, such as tuition, fees, books, supplies, equipment, room, and board (if enrolled at least half-time), computers, and internet access (if required by the school), and special needs services. You can also use up to $10,000 per year per beneficiary for tuition at private elementary or secondary schools (K-12) or eligible apprenticeship programs. You can also use up to $10,000 per beneficiary (lifetime limit) to repay student loans.

Change the beneficiary

If you have leftover money in your 529 plan after your child graduates or drops out of school, you can change the beneficiary of the account to another eligible family member who can use the money for their education expenses. Eligible family members include siblings, cousins, nieces, nephews, parents, grandparents, spouses, and even yourself. You can change the beneficiary as often as you want without any tax or penalty consequences.

Roll over the money to another 529 plan

If you are not satisfied with your current 529 plan, you can roll over the money to another 529 plan for the same beneficiary or a different eligible family member once every 12 months without any tax or penalty consequences. You can also roll over the money to an ABLE account for a disabled beneficiary without any tax or penalty consequences.

Wait until the beneficiary dies or becomes disabled

If your beneficiary dies or becomes disabled before using all the money in their 529 plan, you can withdraw the remaining balance without any tax or penalty consequences. However, you will have to provide proof of death or disability to the 529 plan administrator.

Claim an exception

There are some exceptions that allow you to withdraw money from your 529 plan without paying the 10% penalty (but not the income tax) on the earnings portion. These exceptions include:

The beneficiary receives a tax-free scholarship or grant. You can withdraw up to the amount of the scholarship or grant without paying the penalty.

The beneficiary receives educational assistance from an employer or a veterans program. You can withdraw up to the amount of the assistance without paying the penalty.
The beneficiary attends a U.S. military academy. You can withdraw up to the cost of attendance without paying the penalty.
The beneficiary dies or becomes disabled. You can withdraw the remaining balance without paying the penalty.

In conclusion, the 529 plan is a great way to save for your child’s education expenses and enjoy tax-free growth and withdrawals. However, if you withdraw money from your 529 plan for non-qualified expenses, you will have to pay taxes and penalties on the earnings portion of your withdrawal. This can reduce the value of your savings and discourage you from using your 529 plan for other purposes.

To avoid or minimize a 529 plan penalty, you should use the money for qualified education expenses, change the beneficiary, roll over the money to another 529 plan, wait until the beneficiary dies or becomes disabled, or claim an exception. By doing so, you can make the most of your 529 plan and help your child achieve their educational goals.

Frequently Asked Questions (F&Qs)

What are non-qualified expenses?

Non-qualified expenses are expenses that are not eligible for the tax benefits of a 529 plan. Some examples of non-qualified expenses include:

Room and board if the student is not enrolled at least half-time
Student loan payments
Tuition and fees at a non-eligible educational institution
Purchase of a computer or other equipment that is not required for enrollment or attendance at an eligible educational institution

What are the exceptions to the 10% penalty?

There are a few exceptions to the 10% penalty. For example, there is no penalty for withdrawals made to pay for qualified expenses incurred by a special-needs student.

What are the state penalties for non-qualified withdrawals?

In addition to the federal 10% penalty, some states may impose additional penalties for non-qualified withdrawals. You should consult with the plan administrator to determine the specific rules for your state.

Is there a way to get the 529 plan penalty waived?

In some cases, the 529 plan penalty may be waived. For example, the penalty may be waived if the withdrawal is made to pay for qualified expenses incurred by a special-needs student. You should consult with the plan administrator to determine if there are any circumstances that would allow you to get the penalty waived.