One of the rules governing 529 savings plans, which parents often set up to fund a child’s college education, is that the money must go toward covering qualified education expenses. Otherwise, the earnings portion of any withdrawals will be subject to taxes and a 10% penalty. Happily, there are a number of ways to avoid the penalty (if not the taxes). Here’s a look at how 529 plans work and the exceptions to the rules.

How 529 Savings Plans Work

A 529 savings plan, or a qualified tuition program (QTP) as it is officially known, is a tax-advantaged way to save for a child’s college education (and, as a result of recent changes to the law, for some K-12 education costs as well). Since 2019, it’s also been possible to use up to $10,000 in 529 funds to pay off student loans, and the plans can also cover eligible apprenticeship programs.

All 529 plans are run by individual states. Though the basic rules are laid out in the Internal Revenue Code, Section 529, the states’ plans can differ in their details, including whether they entitle the contributor to a state tax deduction or credit.

Contributions to 529 plans are not eligible for a federal tax deduction, so they represent money that has already been taxed. As a result, account owners (typically parents) can withdraw any part of their original contributions without taxes or penalties.

The account’s earnings, meanwhile, grow tax-deferred and can be withdrawn tax- and penalty-free as long as the money goes toward covering qualified education expenses. In the case of 529 plans, those include tuition, mandatory fees, and room and board. But withdrawals of account earnings for any other purpose are normally subject to income tax and an additional 10% penalty. As this article will explain, however, there are some exceptions.

The 529 Withdrawal Penalty

As mentioned above, if you take a distribution from a 529 plan and use some or all of it to cover non-qualified expenses, you will owe not just federal income tax but, in most cases, an additional 10% penalty on the taxable portion of your withdrawal. The plan administrator will apportion your distribution to include mostly original contributions as well as some earnings. Here’s an example:

Suppose your child has $5,000 in qualified education expenses this semester. You take a total distribution of $6,000 to pay those expenses and also cover some other bills. So you now have $1,000 in non-qualified expenses. If the earnings portion of your $6,000 distribution is $900, your taxes would be calculated as follows:

$5,000 (qualified education expenses) / $6,000 (total distribution) = 0.833 (or 83.3%)

0.833 x $900 (total earnings) = $750 (earnings that aren’t subject to tax)

In other words, the first $750 of earnings in this case counts toward qualified expenses, so it isn’t taxable.

That leaves $150 ($900 – $750) that is subject to taxes and the 10% penalty.

How to Withdraw 529 Plan Funds Without a Penalty

There are several situations in which the 10% penalty on taxable earnings does not apply. These include a distribution taken when the beneficiary dies, becomes disabled, or attends a U.S. Military Academy. The penalty is also waived if the family has to pay income tax on a portion of their 529 withdrawal as a result of claiming the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC). Additional exceptions exist if your child receives certain other types of educational assistance. One of these is the scholarship exception described in the next section.

529 plans and scholarships

If your child receives a tax-free college scholarship or grant, that amount must be deducted from their total qualified education expenses to determine what’s known as their adjusted qualified education expenses (AQEE).

The scholarship exception, however, lets you withdraw up to the amount of that scholarship and use the money for any purpose penalty-free. The earnings on that portion of the distribution will still be subject to income tax. However, if you use the withdrawal for qualified education expenses, the money will be both tax- and penalty-free.

If your child does not receive a scholarship (or meet the requirements for one of the other exceptions) and you withdraw funds that you don’t use for qualified education expenses, you will owe both taxes and a 10% penalty on the earnings.

Timing the scholarship exception

The timing of a 529 plan distribution based on a scholarship has been a subject of debate among tax experts since Section 529 was incorporated into Public Law 104-188 in 1996. Neither Congress nor the IRS offers clear guidance on when the distribution can be made, leading to a split in expert opinion ranging from “there is no time limit” to “you must withdraw the funds before your child graduates” or “the money must come out in the same calendar (tax) year the scholarship was received.”

Enrolled Agent Rachel Murley of RKM Accounting and Tax LLC takes a somewhat constrained approach. “While the IRS does not offer guidance on this topic specifically,” she says, “like most things with the IRS, you must interpret between the lines.”

She points to IRS Publication 970, page 52, which says, “To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.”

Because “a school year and a tax year are not necessarily the same thing,” Murley says, you should figure education expenses using a tax year instead of an academic year. In other words, you should take the distribution in the same calendar year in which you receive the scholarship, she maintains.

However, Peter J. Greco, certified public accountant, founder, and chief tax strategist at the CSI Group, believes you have more latitude. “Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense,” he says. “However, IRS 970 is silent as to when the money must be withdrawn. If Congress is trying to encourage 529 plans, then it makes good policy sense that the withdrawals can be made anytime prior to graduation.”

So what’s the answer? Absent further guidance from the IRS, the following advice seems prudent:

• If possible and to avoid any problems, plan to take the distribution before the end of the calendar year in which the scholarship or grant was awarded.
• If you want to delay taking the distribution beyond the calendar year, contact your plan administrator to make sure there are no state or plan rules that would result in a penalty.
• You might also want to contact a professional tax advisor for counsel.

The Bottom Line

Though it’s all but impossible to avoid paying income tax on 529 distributions that aren’t spent on qualified education expenses, there are a number of ways to at least avoid the additional 10% penalty. And given college costs today, every little bit helps.