The federal government gives tax advantages to investments made in 529 plans, which are operated by states and educational institutions to help individuals save for college. The Internal Revenue Service doesn't offer a deduction for contributions, but the money does grow tax-free in the account. If you use the money for qualified educational expenses, it all comes out of the account tax-free as well. Though you can take money out of the plan at any time, the IRS imposes additional taxes and penalties if the money is used for anything besides qualified expenses.
If you take a non-qualified distribution from your 529 plan, the penalties are two-fold. First, you have to include the earnings portion of the distribution as taxable income. Second, you have to pay an extra 10 percent penalty on the earnings. For example, let's say you have a 529 plan with $20,000 of contributions and $5,000 of earnings, for a total of $25,000. If you take out a $10,000 non-qualified distribution, $8,000 is contributions, which are tax-free, and $2,000 is earnings, which becomes taxable and subject to the 10 percent additional tax.
If you take a qualified distribution from your 529 plan, not only do you not have to pay income taxes on it, you don't even have to report it on your tax return. Qualified distributions refer to those that you use to pay qualified expenses, which include tuition and fees at a post-secondary educational institution, such as a college, trade school or graduate school. For example, if your school charges everyone a campus use fee as a condition of attendance, you could include that cost because it's mandatory. However, if you pay extra to receive student seats at fine arts performances, you can't include that cost because it's optional. You can also include the cost of room and board if you are enrolled at least half-time.
Reducing Qualified Expenses
If you receive tax-free financial aid or claim an education tax benefit, you must reduce your qualifying expenses by those amounts. Tax-free financial aid includes scholarships and grants, but not loans. Educational tax benefits include the American Opportunity Tax Credit, the Lifetime Learning Credit and the tuition and fees deduction. For example, assume you have $14,000 in qualified expenses, but you receive a $5,000 scholarship and use $4,000 to claim the American opportunity credit. As a result, you only have $5,000 in qualified expenses for the purposes of taking a 529 plan distribution.
In certain circumstances, you can take a non-qualified distribution without owing the 10 percent additional tax penalty, though you will still owe income taxes on the earnings. For example, if you inherit the 529 plan and receive the distributions as the beneficiary, you don't owe the 10 percent penalty. You also don't owe the penalty if you are permanently disabled or if the distributions were taxable because you received a tax-free scholarship or attended a U.S. military academy.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."