What Is the 529 Withdrawal Penalty for Non-Qualified Expenses?

When it comes to financing higher education, 529 plans offer a tax-advantaged way to save for college costs. However, the IRS imposes a penalty when 529 account holders use funds from these accounts for non-qualified expenses.

While there is no penalty for leaving leftover funds in a 529 plan account after a student graduates or leaves college, you’ll face taxes and penalties if you use a 529 plan distribution on non-qualified expenses. You’ll have to pay income tax and a 10% withdrawal penalty on the earnings portion.

What is the 529 withdrawal penalty?

The 529 withdrawal penalty is a 10% federal tax on the earnings portion of any distribution used for non-qualified expenses. California even imposes an additional 2.5% state income tax penalty on those earnings, making the total penalty 12.5% in that state.

Here’s how the penalty works:

• 529 plan distributions are allocated between the earnings and contribution (basis) portions.
• The contribution portion will never be taxed or penalized since it was made with after-tax dollars.
• Only the earnings portion is subject to income tax and the 10% penalty when used for non-qualified expenses.
• In many cases, the actual penalty on non-qualified 529 plan distributions is just 1-3% of the total distribution amount – no worse than investing in a taxable savings account or brokerage.

How do I calculate the 529 penalty?

To calculate your 529 penalty, you need to determine what portion of your earnings corresponds to non-qualified expenses. The IRS requires you to prorate the earnings portion of your distribution based on the ratio of qualified to non-qualified expenses.

Here’s a step-by-step example:

In this example, you don’t have to pay tax on $875 of the $1,000 in earnings. The remaining $125 is subject to income tax and the 10% withdrawal penalty. At a 10% penalty rate, you’d pay $12.50 in penalties plus income tax on the $125.

How much can I withdraw from a 529 plan tax-free?

There is no numeric limit for tax-free 529 plan withdrawals as long as the withdrawal amount matches your qualified education expenses. For college costs, you can withdraw as much as needed to cover tuition, fees, books, room and board, computers, and other qualified expenses.

However, K-12 expenses have specific limits. For 2025, the tax-free withdrawal limit is $10,000 per year per beneficiary for K-12 tuition and expenses (increasing to $20,000 in 2026). Eligible K-12 expenses include tuition, curriculum materials, tutoring, online learning subscriptions, educational therapies for students with disabilities, standardized test fees, and dual-enrollment tuition.

What are the exceptions to the 529 withdrawal penalty?

The IRS waives the 10% penalty in specific circumstances, though the earnings portion is still subject to federal and state income tax. These exceptions recognize situations where the beneficiary can’t use the funds for their original intended purpose.

Additionally, beneficiaries can now roll over funds from a 529 plan to a Roth IRA without penalties or taxes, subject to certain requirements. The lifetime maximum for rollovers is $35,000, with annual transfers limited to the Roth IRA contribution limits ($7,000 in 2025, or $8,000 if age 50+).

What expenses qualify for 529 withdrawals?

Qualified 529 plan expenses include costs directly related to enrollment or attendance at eligible educational institutions. These institutions must be eligible to participate in federal student aid programs administered by the U.S. Department of Education, which includes universities, colleges, community colleges, trade schools, and vocational schools.

You may also use 529 funds toward expenses that generate the Lifetime Learning Credit, though you cannot use the same expenses for both the 529 tax-free withdrawal and the tax credit—this would constitute “double-dipping.”

What expenses do not qualify for 529 withdrawals?

Non-qualified expenses are any costs not directly required for enrollment or attendance at an eligible institution. Using 529 funds for these expenses triggers the 10% penalty and income tax on the earnings portion.

Will my state recapture tax deductions on non-qualified withdrawals?

Most states that offer tax deductions or credits for 529 contributions will recapture those benefits when you make a non-qualified distribution. This means you’ll owe back the state tax savings you received on contributions that are later withdrawn for non-qualified expenses.

However, this recapture doesn’t make you worse off than if you’d invested in a regular taxable account instead. The state income tax deduction was a bonus benefit of using a 529 plan. You’re simply returning to the tax treatment you would have received with any other investment.

Check your state’s specific recapture rules to understand how non-qualified distributions affect your state taxes.

How can I avoid the 529 withdrawal penalty?

The best way to avoid penalties is to use 529 funds only for qualified expenses or take advantage of the penalty exceptions. If you have leftover funds, several strategies allow you to avoid taxes and penalties entirely.

Key takeaways

• The 10% penalty applies only to the earnings portion of non-qualified withdrawals, not your original contributions.
• In practice, the penalty often amounts to just 1-3% of the total distribution when you factor in the proration formula.
• The penalty can be waived for death, disability, scholarships, military academy attendance, or when claiming education tax credits.
• You can withdraw unlimited amounts tax-free for college costs, but K-12 withdrawals are capped at $10,000 per year ($20,000 starting in 2026).
• Most states will recapture previously claimed tax deductions on non-qualified withdrawals.
• You can avoid penalties entirely by changing beneficiaries, saving for graduate school, or rolling funds to a Roth IRA.

Frequently asked questions

What happens if I withdraw 529 funds for non-qualified expenses?

The earnings portion of your withdrawal will be subject to federal income tax and a 10% penalty. Your original contributions are never taxed or penalized. Additionally, your state may recapture any tax deductions or credits you claimed on those contributions.

Can I avoid the penalty if my child gets a scholarship?

Yes. If your child receives a tax-free scholarship, you can withdraw an amount equal to the scholarship without paying the 10% penalty. However, you’ll still owe income tax on the earnings portion of the withdrawal. This exception applies to scholarships, fellowships, employer education assistance, and military academy attendance.

Is there a time limit for using 529 funds?

No, 529 plans have no expiration date. You can leave funds in the account indefinitely, change beneficiaries to other family members, or save them for the beneficiary’s graduate school or continuing education later in life. There’s no penalty for simply leaving money in the account.

Do I pay the penalty on my entire withdrawal?

No. The penalty applies only to the earnings portion of non-qualified withdrawals, and even then, only to the portion of earnings that corresponds to non-qualified expenses. Your original contributions are never penalized since they were made with after-tax dollars.

Can I use 529 funds and claim education tax credits?

You cannot use the same expenses for both a tax-free 529 withdrawal and an education tax credit like the American Opportunity Tax Credit or Lifetime Learning Credit. However, if you claim a tax credit and withdraw 529 funds for those same expenses, the 10% penalty is waived (though you’ll still owe income tax on the earnings).

What if I withdraw more than my qualified expenses by mistake?

You’ll need to calculate the taxable portion using the IRS formula that prorates earnings between qualified and non-qualified expenses. The portion corresponding to excess withdrawals will be subject to income tax and the 10% penalty. Consider carefully planning your withdrawals to match your qualified expenses as closely as possible.