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Home » Investing » 529 Plan » What Is A 529 Plan Penalty And How To Avoid It

What Is A 529 Plan Penalty And How To Avoid It

Updated: February 18, 2023 By Robert Farrington

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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.

Table of Contents
What Is a 529 Plan?
Eligible 529 Plan Expenses
Details Of A 529 Plan Penalty
How To Avoid a 529 Plan Penalty
Other Ways To Avoid The 529 Plan Penalty
Stay Within The Qualified Expenses To Avoid Penalties

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:

  • Post-secondary tuition, including college, university, trade schools, vocational programs, and registered apprenticeship programs
  • Room and board, if paid directly to the college or university and the student is attending at least half-time.
  • Books and supplies that are required for classes.
  • Technology items like computers, printers, laptops and even internet service that are required for school
  • K-12 education for public or private school. Tuition is capped at $10,000 per year.
  • Up to $10,000 towards student loan repayment.

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 capital gains 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 a 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 Ways To Avoid The 529 Plan Penalty

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)

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. 

Robert Farrington
Robert Farrington

Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.

He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.

He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.

Editor: Claire Tak

Editorial Disclaimer: Opinions expressed here are author’s alone, not those of any bank, credit card issuer, airlines or hotel chain, or other advertiser and have not been reviewed, approved or otherwise endorsed by any of these entities.
Comment Policy: We invite readers to respond with questions or comments. Comments may be held for moderation and are subject to approval. Comments are solely the opinions of their authors'. The responses in the comments below are not provided or commissioned by any advertiser. Responses have not been reviewed, approved or otherwise endorsed by any company. It is not anyone's responsibility to ensure all posts and/or questions are answered.
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