What Can a 529 Plan Not Be Used For?

A 529 plan serves as a tax-advantaged savings vehicle designed to help individuals save for future education expenses. While these plans offer considerable benefits, including tax-free growth and withdrawals for qualified expenses, understanding their limitations is equally important. Strict rules govern what constitutes a “qualified education expense,” and misusing funds can lead to adverse financial consequences. This article focuses on specific expenses 529 plans cannot cover, crucial for account holders to avoid penalties and taxes.

Expenses Not Covered by a 529 Plan

A 529 plan is intended to cover costs directly related to enrollment and attendance at an eligible educational institution, which includes accredited post-secondary schools and, with limitations, K-12 schools. Many common expenses fall outside these guidelines. General living expenses, such as off-campus rent exceeding the institution’s designated cost of attendance allowance for room and board, are not qualified. General groceries, personal care items, and non-educational travel are excluded.

Transportation and commuting costs, including gas, car maintenance, or public transport passes, are not considered qualified expenses. This applies to airfare for travel home during breaks or for study abroad programs. Fees for extracurricular activities, clubs, or social organizations like fraternities and sororities are also not covered, unless directly required for academic credit or enrollment.

Non-academic supplies and equipment, such as personal laptops or smartphones not specifically mandated by the institution for coursework, do not qualify. Software primarily for entertainment or hobbies is excluded. Health insurance premiums and general medical expenses, even if offered through the educational institution, are non-qualified expenses for 529 plan distributions.

While 529 funds can be used for student loan repayment, this is limited to a lifetime maximum of $10,000 per borrower, including the beneficiary and their siblings. Any principal payments on student loans exceeding this limit or payments toward other personal debts, such as credit card balances, are not qualified uses of 529 funds. For K-12 education, up to $10,000 annually per student can be used for tuition. Other K-12 expenses like uniforms, general books, or school-related transportation are not covered. Beginning July 4, 2025, federal law expands qualified K-12 expenses to include curriculum materials, tutoring, testing fees, and dual enrollment fees.

Tax Implications of Non-Qualified Withdrawals

Using 529 plan funds for expenses not considered qualified education expenses can trigger significant tax implications. The portion of a non-qualified withdrawal attributable to earnings will be subject to federal income tax. This taxable amount is determined on a pro-rata basis, meaning a percentage of the withdrawal is considered earnings, proportionate to the earnings in the entire account. The original contributions, or basis, are not subject to tax since they were made with after-tax dollars.

Beyond federal income tax, an additional 10% federal penalty tax applies to the earnings portion of non-qualified withdrawals. The recipient of the non-qualified distribution, whether the account owner or the beneficiary, is responsible for reporting and paying these federal taxes.

State tax rules vary. Many states also impose their own income tax on the earnings portion of non-qualified withdrawals. Some states may levy additional penalties or require the recapture of any state income tax deductions or credits previously claimed on contributions to the 529 plan.

The 10% federal penalty tax may be waived in certain situations, although earnings remain subject to regular income tax. The penalty is waived if the beneficiary receives a tax-free scholarship, provided the withdrawal amount does not exceed the scholarship amount. Other exemptions from the 10% penalty include the beneficiary’s death or disability, or attendance at a U.S. military academy. Even in these cases, the earnings portion of the withdrawal is still considered taxable income.

Scenarios Leading to Unused or Misused Funds

Situations can lead to a surplus of funds in a 529 plan or a change in the intended use of savings. When the beneficiary receives significant scholarships or grants, reducing their need for 529 funds, the scholarship amount can be withdrawn without incurring the 10% federal penalty tax. However, any associated earnings remain subject to ordinary income tax.

If the intended beneficiary decides not to pursue higher education, changes their educational path, or drops out before fully utilizing the funds, a surplus may occur. Funds may also remain in the account after the beneficiary graduates, having covered all qualified expenses.

To manage these situations and prevent non-qualified withdrawals, several options exist. The account owner can change the beneficiary to another eligible family member, such as a sibling, child, or even themselves, without tax consequences. Funds can also be used to repay qualified student loans, up to a lifetime limit of $10,000 per borrower, including the beneficiary and their siblings.

For beneficiaries with disabilities, funds can be rolled over to an ABLE (Achieving a Better Life Experience) account, up to the annual ABLE contribution limit, less any other contributions made to the ABLE account that year. Up to $35,000 lifetime from a 529 plan can be rolled into the beneficiary’s Roth IRA, provided the 529 account has been open for at least 15 years and other conditions are met, such as the funds being in the 529 for at least five years and adhering to annual Roth IRA contribution limits. These alternatives provide qualified uses for funds that might otherwise be unused, helping account owners avoid penalties.