529 Savings Plan Penalties: What Happens When Funds Aren’t Used for College?

Many parents and grandparents start saving for their children’s or grandchildren’s college education early, often through a 529 savings plan. These plans offer tax advantages for those saving for college, but what happens if the beneficiary doesn’t go to college or there are funds left over? Will you get penalized if money in your 529 savings plan isn’t used for college? The answer is a bit more complex than a simple yes or no. Let’s delve into the details.

What is a 529 Savings Plan?

A 529 savings plan is a tax-advantaged investment account designed to encourage saving for future education costs. Named after Section 529 of the Internal Revenue Code, these plans are sponsored by states, state agencies, or educational institutions. The funds in a 529 plan can be used for tuition, books, and other education-related expenses at most accredited two- and four-year colleges and universities, U.S. vocational-technical schools, and eligible foreign institutions.

Penalties for Non-Qualified Withdrawals

If you withdraw money from a 529 plan and do not use it on an eligible college expense, it is considered a non-qualified withdrawal. This comes with two financial penalties: income tax and a 10% penalty on the earnings portion of the withdrawal.

• Income Tax: The earnings portion of the non-qualified withdrawal will be subject to federal income tax.
• 10% Penalty: In addition to income tax, you’ll also pay a 10% penalty on the earnings. Note that this penalty is waived in certain situations, such as if the beneficiary dies or becomes disabled, or if they get a scholarship.

Exceptions to the Penalty

There are several exceptions to the 10% penalty for non-qualified withdrawals from a 529 plan. These include:

• Scholarships: If the beneficiary receives a scholarship, you can withdraw up to the amount of the scholarship without incurring the 10% penalty. However, you will still owe income tax on the earnings portion of the withdrawal.
• Attendance at a U.S. Military Academy: If the beneficiary attends a U.S. military academy, you can withdraw an amount equal to the cost of education without incurring the 10% penalty.
• Death or Disability: If the beneficiary dies or becomes disabled, you can withdraw the amount without incurring the 10% penalty.

Alternatives to Non-Qualified Withdrawals

If the beneficiary doesn’t need the money for college, there are alternatives to making a non-qualified withdrawal. You can change the beneficiary to another family member, or you can leave the money in the account and let it continue to grow tax-free. You can also use the money for your own education.

In conclusion, while there are penalties for non-qualified withdrawals from a 529 savings plan, there are also exceptions and alternatives. It’s important to understand these rules and consider your options before making a withdrawal.