Why Are My 529 Earnings Being Taxed?

Saving for education with a 529 plan offers tax advantages, but withdrawals may still be subject to taxes in certain cases. Many account holders assume all distributions are tax-free, only to be caught off guard when they see their earnings taxed.

Understanding why this happens can help avoid unexpected costs and ensure full use of the plan’s benefits.

Non-Qualified Distributions

Withdrawals from a 529 plan are tax-free when used for eligible education expenses. However, if funds are used for non-qualified expenses or exceed allowable limits, the earnings portion becomes taxable, and a 10% federal penalty may apply.

Surpassing Expense Limits

The IRS limits tax-free withdrawals to the amount spent on qualified education expenses each year. If withdrawals exceed actual costs, the earnings portion of the excess is taxable and may incur a penalty.

For example, if a student’s tuition and other qualified expenses total $15,000 but $18,000 is withdrawn, the earnings portion of the extra $3,000 will be taxed and may face the 10% penalty. Keeping detailed records of expenses and withdrawals helps prevent over-withdrawals and unnecessary taxes.

Unapproved Costs

Not all education-related expenses qualify for tax-free withdrawals. Tuition, mandatory fees, books, and certain room and board costs for students enrolled at least half-time are covered, but transportation, health insurance, and student loan payments do not qualify. Using 529 funds for these results in taxable earnings and a possible penalty.

Some states define qualified expenses differently, affecting state tax treatment. While federal law allows 529 funds for K-12 tuition and student loan payments, states like California and New Jersey do not, meaning withdrawals for these purposes may be taxed at the state level. Reviewing IRS guidelines and school billing statements can clarify which expenses qualify.

Withdrawals for Non-Education

If funds are withdrawn for non-educational purposes, the earnings portion is subject to federal income tax and the 10% penalty. This applies if a beneficiary decides not to attend college or if the account owner needs the funds for other expenses.

There are exceptions to the penalty. If the beneficiary receives a tax-free scholarship, enrolls in a U.S. military academy, or becomes disabled, the 10% penalty is waived, though the earnings portion remains taxable. To avoid taxes, funds can be transferred to another eligible family member’s 529 plan instead of taking a non-qualified distribution.

Conflict with Education Tax Credits

Using a 529 plan alongside education tax credits like the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC) requires careful coordination. The IRS does not allow the same expenses to be used for both tax-free 529 withdrawals and education tax credits.

For example, the AOTC provides up to $2,500 per student, covering 100% of the first $2,000 of qualified expenses and 25% of the next $2,000. If a student has $10,000 in tuition and fees and claims the AOTC for $4,000 of that amount, only $6,000 remains eligible for tax-free 529 withdrawals. If the full $10,000 is withdrawn from the 529, the earnings portion of the extra $4,000 becomes taxable.

To maximize benefits, families can use personal funds or scholarships for expenses needed to claim tax credits while reserving 529 withdrawals for remaining costs. Timing distributions across multiple tax years can also help avoid conflicts.

State-Level Tax Regulations

While federal tax rules for 529 plans are consistent, state regulations vary and can impact both contributions and withdrawals. Many states offer tax deductions or credits for contributions to in-state plans, but some impose taxes on certain withdrawals.

For instance, New York allows residents to deduct up to $5,000 per year ($10,000 for married couples filing jointly) for contributions to the state’s 529 plan. However, if funds are later rolled over to another state’s plan or used for non-qualified expenses, the deducted amount may be subject to recapture. In Illinois, taxpayers who claim a deduction but later transfer funds to an out-of-state 529 plan must add back the deducted amount as taxable income.

Some states tax withdrawals that are federally qualified. The SECURE Act expanded 529 usage to include student loan repayments and K-12 tuition, but states like California and New Jersey still tax withdrawals for student loan payments. This creates unexpected liabilities for account holders who assume all qualified withdrawals receive the same treatment at the state level.

Reporting Mistakes and Documentation Errors

Errors in reporting 529 withdrawals can lead to unintended taxes, even when funds are used correctly. The IRS requires accurate documentation to verify that distributions match qualified education expenses.

One common mistake is withdrawing funds in one tax year while paying tuition in another. If a withdrawal is made in December but the tuition payment occurs in January, the IRS may classify the distribution as non-qualified, resulting in taxable earnings and penalties.

Another issue is failing to keep proper records. Schools issue Form 1098-T, which reports tuition payments, but this form does not include all qualified expenses, such as required textbooks or certain room and board costs. Without receipts or invoices, taxpayers may struggle to prove expenses if audited. Keeping a detailed log of payments, including school statements and receipts, helps ensure compliance and avoid tax disputes.