California 529 Withdrawal Rules You Should Know

A 529 plan provides a tax-advantaged method for saving for future education costs. Named after Section 529 of the Internal Revenue Code, these plans allow investment earnings to grow deferred from federal and state taxes. When the money is taken out for appropriate educational uses, the withdrawals can be entirely tax-free. This article focuses on the rules and procedures for withdrawing funds from California’s ScholarShare 529 plan, covering both qualified and non-qualified situations.

Qualified Withdrawals for Educational Expenses

A primary advantage of the ScholarShare 529 plan is the ability to take withdrawals free from federal and California state income tax, provided the funds are used for qualified expenses. The scope of these expenses is broad, covering various stages and types of education, from K-12 through postsecondary and apprenticeship programs.

The most common use of 529 funds is for qualified higher education expenses (QHEE) at eligible postsecondary institutions, which include most accredited colleges, universities, and vocational schools. These expenses encompass tuition and mandatory fees, books, supplies, and equipment needed for courses. For students enrolled at least half-time, certain room and board costs are also considered qualified. This includes on-campus and off-campus housing costs, up to the amount specified in the institution’s cost of attendance allowance.

Beyond traditional college costs, account owners can withdraw up to $10,000 per beneficiary per year for tuition at an elementary or secondary public, private, or religious school. While these K-12 tuition withdrawals are free from federal income tax, California does not conform to this rule; the earnings portion of such a withdrawal is subject to California income tax and a 2.5% state penalty.

The rules also permit funds to be used for certain non-traditional educational paths and for paying down existing student debt. Expenses for fees, books, and supplies required for participation in a registered apprenticeship program are considered qualified. Additionally, a lifetime limit of $10,000 per individual can be withdrawn to repay a qualified education loan. This benefit extends to the beneficiary’s siblings as well.

Non-Qualified Withdrawals and Tax Consequences

Taking a distribution from a ScholarShare 529 plan for any reason other than qualified expenses results in a non-qualified withdrawal. The financial consequences are calculated solely on the earnings portion of the distribution, not the original contributions. Your basis, or original contributions, can always be withdrawn tax- and penalty-free.

When a non-qualified withdrawal occurs, the earnings are subject to several layers of taxes and penalties. At the federal level, the earnings are taxed as ordinary income at the recipient’s marginal tax rate. On top of the income tax, the IRS imposes a 10% additional federal tax penalty on those same earnings.

California imposes its own set of taxes on the earnings from a non-qualified withdrawal. The earnings are subject to California’s ordinary income tax. In addition to the state income tax, California applies a 2.5% state tax penalty on the earnings. This is a separate penalty from the 10% federal one.

For example, imagine you take a $10,000 non-qualified withdrawal, of which $7,000 is your original contribution (basis) and $3,000 is investment earnings. The taxes and penalties would only apply to the $3,000 earnings portion. You would owe federal income tax on the $3,000, a $300 (10%) federal penalty, California income tax on the $3,000, and a $75 (2.5%) California penalty. The original $7,000 contribution is returned to you without any tax or penalty.

The Withdrawal Process from ScholarShare 529

Account owners can request a withdrawal through the plan’s online portal, over the phone, or by submitting a paper Withdrawal Request Form. The online method is the fastest way to process the request. When making the request, you will need to specify the amount of the withdrawal and whether it is a qualified or non-qualified distribution.

You can choose to have the payment made directly to the account owner, which is often used for reimbursement of expenses already paid. Alternatively, the payment can be sent directly to the beneficiary (the student). A third option is to have the funds sent directly to the eligible educational institution to be applied to the student’s account balance.

To complete the withdrawal request, you will need basic information, including the account number and the name and address of the payee. If sending funds directly to the institution, you will likely need the school’s address and the student’s ID number. Payments can be sent via standard mail or through an electronic Automated Clearing House (ACH) transfer if your bank account information is on file.

Tax Reporting for All Withdrawals

After any withdrawal is made from a ScholarShare 529 plan during the calendar year, the plan administrator is required to issue IRS Form 1099-Q, “Distributions From Qualified Education Programs.” This form is sent to the recipient of the funds, which could be the account owner or the student. The form provides a summary of the total distributions for the year for tax filing purposes.

Form 1099-Q details the financial components of your withdrawal. Box 1 shows the gross distribution amount, Box 2 reports the portion of that distribution that consists of earnings, and Box 3 reports the basis. It is the account owner’s responsibility to use this information to correctly report the transaction on their tax returns.

To demonstrate that a withdrawal was tax-free, you must be able to show that you spent at least as much on qualified education expenses as the total distribution amount shown in Box 1 of the 1099-Q. You should retain all receipts, invoices, and statements for qualified costs. If the earnings portion of a withdrawal is deemed taxable, that amount is reported as “Other Income” on your federal Form 1040 and the corresponding line on your California state tax return.