If you missed the earlier posts in this series, find them here: Getting Started Simply: How the College Financial Aid Process Works, Long-Term Strategies for Paying for College & 529 College Savings Plans.
I speak to many clients who are worried about saving into 529 college savings plans. They fear their child may not use the money because of earned scholarships, attending school overseas, or not going to college. Below is a brief Q&A and synopsis of your options, if you’re afraid of finding yourself with the problem of excess 529 savings and having to take non-qualified distributions.
As a quick review, contributions to your 529 plan grow tax deferred and earnings are tax free, if the money is used to pay the beneficiary’s qualified education expenses. The earnings portion of any withdrawal not used for qualified college costs is taxed at the recipient’s income tax rate and subject to a 10% penalty.
Qualified 529 plan withdrawals include:
- Tuition and fees
- Equipment required for course enrollment (including special needs equipment)
- Some room and board expenses
Some easily mistaken non-qualified withdrawals include:
- Transportation costs
- Computers (unless the school requires them)
- Student loan repayments
Q: What is the penalty for using leftover 529 plan funds for non-qualified expenses?
A: The first rule to know is that only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty. Distributions are allocated between principal and earnings on a pro-rata basis. That means that your withdrawal is divided into contribution and earnings based on the following formula: Account Contributions / Account Value x Distribution = Contribution Portion. Your contributions (the amount you originally deposited) will never incur a penalty.
Q: Are there exceptions to the 10% penalty rule for scholarships and other circumstances?
A: Yes! If the 529 account beneficiary receives a scholarship or is admitted to a U.S. Military Academy, the amount of the scholarship or value of the military education may be withdrawn from the 529 account without incurring the 10% penalty. Additionally, if the beneficiary dies or becomes disabled, no 10% penalty applies to your withdrawals.
Note: In all of these cases, all earnings on non-qualified distributions will still be subject to tax as ordinary income at your tax rate. However, some 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a lower tax bracket. In addition, if you were able to deduct your original contributions on your state income tax return, you will generally have to report additional state “recapture” income.
Q: What are the alternatives to incurring penalties for taking non-qualified distributions from 529 funds?
A: Consider changing the beneficiary to another qualifying family member who may attend college, or continue to grow the funds in the account in case the original beneficiary wants to pursue graduate school later. You also might make yourself the beneficiary and further your own education.