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529 Plan Withdrawal Penalty

Updated on June 1, 2010

Charges For Withdrawing from 529 Plans

Penalty For Withdrawing From 529 Plans Cost

There is no Income Tax deduction for contributions that are invested into 529 plans. However, the capital gains and all dividends are earned tax-free. Some states have a state income tax deduction for residents who use the state’s 529 plan. All money is taken out to pay for qualified education expenses is tax-free. There are limits on 529 plan contributions.

Since 529 Plans have special tax treatment for a college savings plan, the IRS ensures that the monies are used for their intended purpose, and not for cheating taxes. Therefore, withdrawals must be used to pay qualified educational expenses. Otherwise, there can be taxes and penalties on any withdrawn amount.

Qualified educational expenses include tuition, books, room and board, and student fees. Additionally, thanks to the American Recovery and Reinvestment Act of 2009 (ARRA) other new 529 plan expenses such as computer equipment and computer software were added to the list of qualified expenses. Also allowable is the expense of Internet access and related services.

In addition to the requirement that 529 investments be spent on educational expenses, the expenses must be from attending an eligible educational institution such as a university or community college. Most colleges, universities, specialty schools, trade schools, and vocational schools are eligible. A good rule of thumb is that if they are eligible to participate in federally administered financial aid programs, then the most likely do qualify as eligible institutions.

Any withdrawals that are not for proper educational expenses are subject to penalties and income taxes. Funds not used for college expenses are taxed as ordinary income. In addition, any non-education withdrawal is subject to a 10% penalty.

Even with the taxes and penalties, most 529 plan accounts will save enough money in taxes on the earnings and interest over their lifetimes that they will still be worthwhile even for children who end up not going to college. Of course, the other option is to just change the beneficiary of the 529 account to someone who is going to college. That can be done tax-free.

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