529 Penalty for Non-Education Expenses: What You Need to Know

A 529 plan is a tax-advantaged savings account designed to help families save for education expenses. While these plans offer significant benefits, using the funds for non-qualified expenses results in penalties and taxes. Many account holders are unaware of the financial consequences of withdrawing money for purposes other than education.

Understanding these penalties, along with possible exceptions and reporting requirements, helps avoid unnecessary costs.

Penalty Basics for Non-Education Withdrawals

When funds from a 529 plan are used for non-qualified expenses, the IRS imposes income tax and a 10% penalty on the earnings portion of the withdrawal. The penalty applies only to investment gains, not the total amount withdrawn. If an account holder withdraws $10,000 and $4,000 of that represents earnings, the penalty is $400.

The earnings portion is also subject to federal income tax at either the beneficiary’s or account owner’s tax rate, depending on who receives the distribution. Some states impose additional taxes or require repayment of state tax deductions previously claimed. In New York, for example, any state tax deductions must be repaid if funds are withdrawn for non-qualified purposes.

If a withdrawal includes both contributions and earnings, only the earnings are taxed and penalized. Contributions remain tax-free since they were made with after-tax dollars.

Scholarship Exceptions

Receiving a scholarship can reduce the need for 529 plan funds, but the money doesn’t have to go to waste. The IRS waives the 10% penalty on withdrawals up to the amount of a scholarship received. However, the earnings portion is still subject to federal and possibly state income tax.

This exception applies to scholarships covering tuition, fees, and other qualified education expenses, including merit-based, athletic, and need-based awards. If a student receives a full-ride scholarship, families can withdraw the excess funds or leave them in the account for future use, such as graduate school or transferring to another beneficiary.

To minimize the tax burden, some families withdraw only part of the funds in a given year. Spreading withdrawals over multiple years can prevent income from pushing them into a higher tax bracket. Keeping the funds in the account allows them to be used for future education expenses without tax consequences.

Determining the Taxable Portion

When withdrawing funds for non-qualified expenses, only the earnings portion is taxed. The IRS requires a pro-rata formula to determine how much of a withdrawal comes from investment gains versus contributions.

For example, if a 529 account holds $50,000—$35,000 from contributions and $15,000 from earnings—30% of any withdrawal is considered taxable earnings. If $10,000 is withdrawn, $3,000 is subject to income tax and the 10% penalty.

529 plan administrators typically provide statements detailing the breakdown between contributions and earnings, but account holders should verify these figures, especially if multiple withdrawals have been made.

Reporting Requirements on Tax Returns

Withdrawals from a 529 plan, whether qualified or non-qualified, must be reported to the IRS using Form 1099-Q. This form, issued by the plan administrator, details the total distribution, the earnings portion, and the amount of contributions included. The recipient—either the account owner or beneficiary—determines who reports the income and pays any applicable taxes. If the funds go to the beneficiary, they report the earnings as taxable income. If the account owner receives the funds, they are responsible for the tax liability.

Non-qualified withdrawals must be reported as “Other Income” on Form 1040. The 10% penalty is listed separately on Schedule 2, Line 8, under Additional Taxes. If the withdrawal qualifies for an exemption, such as one related to a scholarship, documentation is required to justify waiving the penalty.