What Is the Penalty for Withdrawing From a 529 Plan?

A 529 plan is a tax-advantaged investment account designed to help individuals save for future education expenses. These plans, authorized by Internal Revenue Code Section 529, are sponsored by states or educational institutions. Money invested grows tax-free, and withdrawals are also tax-free when used for qualified education expenses. However, certain withdrawals not used for eligible purposes can incur penalties and become subject to income tax.

Understanding Qualified Withdrawals

A qualified withdrawal from a 529 plan is one used to pay for eligible education expenses. This allows both the principal and any earnings to be distributed tax-free at the federal level. Eligible expenses include a broad range of costs associated with enrollment or attendance at an eligible educational institution, such as colleges, universities, vocational schools, or other postsecondary institutions participating in U.S. Department of Education student aid programs.

Qualified expenses include:
Tuition and fees, books, supplies, and equipment.
Room and board, provided the student is enrolled at least half-time, with limits tied to the institution’s cost of attendance for federal financial aid.
Computer technology, related equipment, and internet access used by the beneficiary and their family while enrolled.
Up to $10,000 per year in tuition for K-12 public, private, or religious schools per beneficiary.
Expenses related to registered apprenticeship programs.
Student loan repayments, with a lifetime limit of $10,000 per beneficiary or their sibling.

Non-Qualified Withdrawals and the Penalty

A non-qualified withdrawal occurs when funds are taken from a 529 plan and not used for qualified education expenses. The earnings portion of the withdrawal becomes subject to both ordinary income tax and an additional 10% federal penalty tax. This penalty and taxation apply only to the earnings, as original contributions were made with after-tax dollars and are returned tax-free and penalty-free.

For example, using 529 funds for general living expenses, travel costs, or health insurance not explicitly required by the educational institution triggers this penalty. Withdrawing more funds than the actual qualified education expenses incurred in a given tax year can also result in the excess earnings being treated as a non-qualified distribution. The Internal Revenue Service expects distributions to be used for qualified expenses in the same tax year the expenses are paid.

Situations Exempt from the Penalty

While non-qualified withdrawals incur a 10% federal penalty, specific circumstances allow for the waiver of this tax. However, the earnings portion may still be subject to ordinary income tax.

Exceptions include:
The beneficiary dies or becomes disabled. Funds can be withdrawn without the 10% penalty, though any earnings are still taxed as income.
The beneficiary receives a tax-free scholarship. The penalty is waived on non-qualified withdrawals up to the scholarship amount, as the scholarship covers expenses the 529 funds would have.
The beneficiary attends a U.S. military academy. Withdrawals up to the estimated cost of attendance at the academy can be made penalty-free, though earnings remain subject to income tax.
The withdrawal amount equals qualified higher education expenses used to claim federal education tax credits, such as the American Opportunity Tax Credit or the Lifetime Learning Credit. However, the same expenses cannot be used for both a tax-free 529 withdrawal and an education credit. Expenses used for the credit must be distinct from those covered by the tax-free 529 distribution, or the 529 withdrawal amount corresponding to the credited expenses will become taxable on its earnings.

Reporting 529 Withdrawals for Tax Purposes

When withdrawals are made from a 529 plan, the plan administrator is required to issue Form 1099-Q, “Payments From Qualified Education Programs (Under Sections 529 and 530).” This form reports the total distributions from the account for the tax year. Form 1099-Q provides three key pieces of information: the gross distribution in Box 1, the earnings portion in Box 2, and the basis (contributions) portion in Box 3.

Recipients use Form 1099-Q to determine the taxability of their withdrawals. If the total distribution is less than or equal to the adjusted qualified education expenses, the earnings are not included in income. However, if withdrawals exceed qualified expenses or are used for non-qualified purposes, the earnings portion reported in Box 2 may be taxable. Any taxable earnings from a non-qualified withdrawal are reported as “Other Income” on Schedule 1 (Form 1040), and the 10% additional tax is reported on Schedule 2 (Form 1040). Maintaining detailed records of qualified expenses throughout the year is important to accurately reconcile distributions with expenses and properly report them for tax purposes.