A 529 plan, also called a qualified tuition plan, is set up to help a student pay for college. 529 plans offer some advantages over standard savings or investments. The main benefit is that any plan earnings can be used, tax-free, to pay for school. Taking the money out before a student is ready for college or using it for non-college related expenses leads to penalties.
If you pull the money out of a 529 plan to use for anything besides a qualified education expense for the beneficiary, you'll owe income tax on the earnings alone. You've already paid the tax on the original contribution, so you won't owe additional income tax on that amount. The tax can either be paid by the beneficiary or by the person who originally contributed the money. If you take the money out to pay for a 10-year-old beneficiary's leg surgery, it might make sense to put the withdrawal in the beneficiary's name, as he will be in a lower tax bracket than the account owner.
Along with income tax on any earnings, you'll have to pay a 10 percent penalty on earnings you withdraw before it's time for the beneficiary to go to college. The penalty only applies to earnings, not the original contribution. There are exceptions to the penalty for a non-qualified or early withdrawal. For example, if the 529 plan lost money, you won't have to pay the penalty or income tax, as there were no earnings.
Avoiding the Penalty
If the plan did have earnings and you remove the money before the beneficiary goes to college, there are a few exceptions to the penalty, but not income tax. If the beneficiary died or has become permanently disabled, you can withdraw the money without penalty. You can also avoid the penalty if the beneficiary received a tax-free source of funding for school, such as a scholarship or educational assistance from the military or his employer, as long as the amount withdrawn isn't more than the scholarship or other financial assistance.
If the beneficiary realizes early on that he won't be attending college or another post-secondary program, there are ways to use the money that aren't subject to the penalty. You can change the name of the beneficiary on the 529 plan to avoid any non-qualified distributions, income taxes and penalties. The new beneficiary needs to be related to the original in some way, such as a sibling, spouse or first cousin. When you change the beneficiary, the same rules for withdrawing the money apply.
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