529 Disability Exception: How to Withdraw Funds
When a 529 beneficiary has a disability, the plan's purpose can shift. Understand the regulations for accessing funds and managing the account's future.
A 529 plan is a savings account designed to encourage saving for future education costs on a tax-advantaged basis. Funds within these plans grow federally tax-deferred, and withdrawals are tax-free when used for their intended purpose. To receive this favorable tax treatment, the money must be spent on qualified education expenses.
Standard 529 Plan Withdrawal Rules
The rules governing 529 plans distinguish between two types of withdrawals. A “qualified withdrawal” aligns with the plan’s purpose, covering legitimate education expenses for the designated beneficiary. These distributions are free from federal income tax and penalties. This includes expenses for K-12 tuition, apprenticeship programs, and up to $10,000 in student loan repayments.
A “non-qualified withdrawal” occurs when funds are taken out for any reason other than these specified educational costs. When this happens, the earnings portion of the withdrawal faces two financial consequences. It is subject to ordinary income tax at the account owner’s rate, and the IRS imposes a 10% federal tax penalty on those same earnings. These consequences apply only to the investment gains, as the original contributions can always be withdrawn tax- and penalty-free.
Understanding the Disability Penalty Waiver
An exception exists within the tax code that allows for penalty-free access to 529 funds if the beneficiary develops a disability. This provision waives the 10% federal penalty on non-qualified withdrawals, providing financial flexibility to families. The waiver specifically targets the penalty, meaning that while the charge is removed, other tax rules still apply.
To be eligible for this waiver, the beneficiary must meet the IRS definition of disability. A person is considered disabled if they can provide proof that they are unable to engage in any “substantial gainful activity” due to a physical or mental condition. A physician must certify that this condition is expected to result in death or be of a long-continued and indefinite duration. This standard requires a severe and lasting impairment.
While the penalty is waived, the earnings portion of the withdrawal is still considered taxable income to the person who receives the funds. For example, if a 529 account holds $50,000, of which $30,000 is contributions and $20,000 is earnings, the 10% penalty on the $20,000 is waived. However, that $20,000 must be reported as ordinary income on the recipient’s tax return.
Process for Claiming the Disability Exception
The account owner must gather the necessary documentation to prove the beneficiary’s disability status to the IRS. This is a self-reporting process, meaning the responsibility falls on the taxpayer to substantiate the claim if questioned. The primary proof is a formal certification from a physician detailing the condition.
With the required documentation, the next step is to contact the 529 plan administrator to request the distribution. The account owner should state that the withdrawal is due to the beneficiary’s disability to ensure it is coded correctly. After the withdrawal, the plan administrator will issue Form 1099-Q, “Payments From Qualified Education Programs,” to the recipient. Review this form to confirm the distribution is properly noted to reflect the penalty exception.
Alternative Options for the 529 Account
If the original beneficiary cannot pursue higher education, the account owner has other ways to manage the funds. The account owner can change the beneficiary without tax or penalty, provided the new beneficiary is an eligible family member of the original one. This includes relatives such as:
- Siblings or stepsiblings
- Parents
- Aunts or uncles
- Nieces or nephews
- First cousins
Another alternative is to roll the 529 plan funds into an ABLE (Achieving a Better Life Experience) account for the same beneficiary. An ABLE account is a tax-advantaged savings vehicle for individuals with disabilities, and funds can be used for a broad array of qualified disability expenses. Under a provision set to expire at the end of 2025, the rollover from a 529 to an ABLE account is tax-free. The amount transferred is subject to the annual ABLE contribution limit of $19,000.