Non-Qualified 529 Withdrawals Lead To Exceptions

529 plans offer many tax benefits to help you save over time for your children’s future college costs. These benefits include: tax-free earnings; tax-free withdrawals, provided that the account is used for qualified higher education expenses; and State of Ohio tax deduction for Ohio residents.

You can request funds from the 529 plan for non-qualified withdrawals, but the earnings will be taxed on the federal, state, and local level. Additionally, like other tax-advantage saving programs, there is a 10% federal tax penalty assessed for withdrawing money from the 529 plan for costs that aren’t considered qualified higher education expenses. However, there are three specific exceptions to this federal tax penalty:

1. Scholarships
2. Attendance in a U.S. military academy
3. Death or permanent disability of the 529 plan’s beneficiary

1) Scholarships. If the 529 plan beneficiary earns a scholarship, you can withdraw up to the same dollar amount as the scholarship from the 529 plan within the same calendar year. It’s a non-qualified withdrawal because it’s not used to pay 529-qualfied higher education expenses such as tuition, mandatory fees, computer equipment and related technology and services, books, supplies, and equipment required for enrollment or attendance; room and board costs during any academic period the beneficiary is enrolled at least half-time; and certain expenses for a special-needs student. However, since the scholarship covered these qualified costs, only the earnings portion of the withdrawal will be subject to federal, state, and local income taxes. Please note that any amount withdrawn to cover qualified higher education expenses over and above the amount of the scholarship would be considered a qualified withdrawal.

2) Attendance at a U.S. military academy. You may make a non-qualified withdrawal up to the estimated cost of attendance within the same calendar year at a military academy without incurring the additional 10% federal tax penalty. Again, the earnings portion of such withdrawal will be subject to federal and state income taxes.

3) Death or permanent disability of beneficiary. In the unfortunate event where the beneficiary has passed away, you may elect to choose a new beneficiary (who must be a member of the family of the previous beneficiary) for the 529 plan account without penalty. Another option is that you can authorize a payment to the estate of the beneficiary. The earnings portion of a payment to the beneficiary’s estate will not be subject to the additional 10% federal tax penalty, but will be subject to federal,  state, and local income taxes. If the beneficiary of the 529 plan becomes permanently disabled, then you may select a new beneficiary or withdraw all or a portion of the account. The earnings portion of any withdrawal will not be subject to the additional 10% federal tax penalty, but will be subject to federal, state, and local income taxes.

Rollovers
There is one another unique circumstance where the 10% federal tax penalty may not be assessed on a withdrawal: Rollover withdrawals to another 529 plan. If you withdraw funds to roll them over to another qualified 529 plan for the same beneficiary, then the earnings portion of such withdrawal would not be subject to federal, state, and local taxation, nor the additional 10% federal tax penalty, provided it has been more than 12 months since any previous rollover was done for that same beneficiary, and the funds must be deposited to another 529 plan within 60 days of the withdrawal.

You also may withdraw funds and roll them out to an account in another state’s 529 plan at any time without federal tax consequences when the account beneficiary is changed, provided that the new beneficiary is a member of the family of the previous beneficiary. The funds must be deposited to another 529 plan within 60 days of the withdrawal. A CollegeAdvantage 529 plan rollover withdrawal to another state’s 529 plan will be subject to recapture of any State of Ohio tax deductions claimed in prior years.

Again, a 529 plan rollover that does not meet these criteria in these two circumstances will be considered by the IRS to be a non-qualified withdrawal; therefore, the 529 plan rollover will be subject to taxation at both the federal and state level and is subject to recapture of any State of Ohio tax deductions claimed in prior years.

You always have access to all the funds saved in a 529 plan. It is the intended use of the withdrawal that determines if there will be federal and state tax applied and/or a 10% federal tax penalty assessed on the earnings in the withdrawal, Before making a qualified or non-qualified withdrawal, you should consult your financial advisor or tax consultant.

If you haven’t signed up for a CollegeAdvantage Direct 529 Plan yet, are you ready to become a an account owner for one of your loved ones? Visit  here to sign up today. To help you monitor your investments and make investment decisions that are right for your savings strategy, there are online tools and calculators. These resources are provided for informational purposes only, so you should again consult your financial advisor or tax consultant about your personal situation and savings goals.