What Is The 529 Plan Penalty And How To Avoid It

One of the biggest fears families have about using a 529 plan to save for college is the dreaded 529 plan penalty.

There are many ways to save and pay for college, and the absolute best way to do it varies depending on your specific situation. A 529 plan, which is designed to help you with higher education expenses, is a type of tax-advantaged account that allows you to save and invest money.

As long as you withdraw that money for qualified expenses, you can do so without paying taxes on it. However, if you don't use the funds in your 529 plan for qualified education expenses, you may be assessed a tax penalty.

Thankfully, it's fairly straightforward to avoid this 529 plan penalty, as long as you take a few precautionary steps.

What Is a 529 Plan?

529 plans are a type of account that is typically used for saving for college and other higher educational expenses. 529 plans are run by individual states. You can open a 529 plan in a variety of states, not necessarily the one you currently live in. 

However, many states give tax deductions or tax credits for contributing to their specific 529 plan. So one of our best 529 tips is to consider opening your plan in the state you live in (or pay taxes in) to take advantage of these tax benefits, if you're eligible.

It's relatively easy to set up a 529 plan, and you can set them up for a beneficiary (i.e. children). While each 529 account has a specific beneficiary, you are able to change the beneficiary at any time. 

This can be useful if one of your children earns a full-ride scholarship or decides not to attend college. The funds in their account don't have to go to waste—instead, you can use that money for a different beneficiary (i.e. a different child or person). 

Also, you don't have to be a parent to open a 529 plan for someone. Grandparents, aunts, uncles and others can open a 529 plan.

Eligible 529 Plan Expenses

One of the key parts of how 529 plans work is that you must use them to pay for qualified education expenses. However, it's more than just college tuition that is eligible—there are a number of qualified 529 plan expenses. 

Here are some:

Make sure that you check your state's 529 plan rules! Some states don't allow you to use a 529 plan for K-12 education or student loan repayment.

Details Of A 529 Plan Penalty

If you use money in a 529 plan for something other than a qualified educational expense, you will likely incur a 529 plan penalty.

The 529 plan penalty is 10% on the earnings portion withdrawn for a non-qualifying expense. 

You will also have to pay ordinary income taxes on the earnings portion of the non-qualifying withdrawal. 

Finally, you might face state taxes as well. Some states will recapture any tax deduction received on the contributions, while others (like California) will assess a flat penalty tax.

Remember, all 529 plan distributions are allocated between the earnings and contribution (basis) portions. Since your contribution was after tax, you only face the taxes and penalties on the earnings/gains. However, you could face state recapture issues on deductions or tax credits received.

Consult with your tax preparer to make sure that you are correctly accounting for any fees or penalties that you owe.

It's important to remember that penalties and taxes lower the value of your 529 plan, so you should avoid incurring it if at all possible.

How To Avoid The 529 Plan Penalty

While a 529 plan penalty of 10% on top of any state penalties and additional tax owed can be a large amount, the good news is that it's fairly easy to avoid these fees. The best thing to do is to make sure that you keep good records of your withdrawals. You'll also want to make sure that you stay within the 529 plan contribution limits. 

If the beneficiary of your 529 plan (often your child) does not go to college or doesn't use up the money, you have options other than just closing the account and paying the penalty. Here are a few considerations: 

• Change the beneficiary, to another child or even yourself.
• Use the money to help pay for higher education expenses for a grandchild or other family member.
• Let the money stay in the account, and transfer account ownership to your child in the future (so they can use the money for their future family)
• Change the beneficiary to yourself or a child and rollover the excess 529 plan funds into a Roth IRA

Basically, you have the potential to setup a 529 plan as a long-living educational trust for your family. If you don't need the money, you can let it grow for the future!

Other (Less Common) Options

There are some other ways to avoid the 529 plan penalty, but they are less common. However, it's important to remember that in these scenarios, the earnings portion of the distribution is still subject to income tax. 

The 10% 529 plan penalty may be waived if:

• The beneficiary dies or becomes disabled
• The beneficiary receives a tax-free scholarship
• The beneficiary receives educational assistance through a qualifying employer program
• The beneficiary attends a U.S. Service Academy (Army, Navy, Air Force, Coast Guard, Merchant Marine)
• You return the over-withdrawal or unused funds in a qualified period of time

Stay Within The Qualified Expenses To Avoid Penalties

529 plans are one of the best ways to save for college and other higher education expenses. Your money can grow tax-free and you may even get a deduction or credit on your state income taxes. 

As long as you use the money in your 529 plan for qualified education expenses, you won't have to pay income tax on your contributions or the growth in your account.

But if you withdraw money from your 529 plan for non-qualified expenses, you will pay a 529 plan penalty. This penalty is 10% of the withdrawn amount, and the money will also be treated as ordinary income, meaning you'll have to pay income taxes on it as well. 

Some states may also charge an additional penalty on non-qualified withdrawals. 

Want to learn more about 529s? See our Ultimate Guide.