We have extra 529 plan money. How is it taxed if I take it out?

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Q. We have more money in our 529 plans that we need. Let’s say I contributed $20,000 and the gains were another $8,000. If I take the money out, I understand I would face tax and penalties on the earnings and not on the original contributions. But what if I wanted to withdraw the original contributions? Is it taxed on a first in, first out (FIFO) basis?
— Mom

A. Congrats on having this extra money sitting around.

FIFO rules do not apply to non-qualified distributions from a 529 plan.

Instead, you would have to pay taxes and a penalty, if applicable, on the portion of the withdrawal that is attributable to your gains, said Marnie Hards, a certified financial planner with Aznar Financial Advisors in Morris Plains.

She offered this example: Let’s say you contributed $15,000 to a 529 plan and you have earned $10,000 in gains for a total balance of $25,000. If you take $5,000 out for non-qualified expenses, you will have to pay a penalty and taxes on $2,000 of the distribution because that is the portion of the withdrawal attributable to your gains, Hards said.

The calculation is as follows: $10,000 of the $25,000 (40% of the total) is attributable to the gains, so when you withdraw money for non-qualified expenses, that 40% percent is the amount of the withdrawal attributable to the gains. $5,000 times 40% equals $2,000, so that is the portion you must pay taxes and a penalty on.

“So in your case, if you withdrew $20,000 of the $28,000 total for non-qualified expenses, you would have to pay taxes and a penalty of $5,714 of the $20,000 withdrawal,” Hards said. “Earnings of $8,000 divided by total balance of $28,000 is the percentage of the withdrawal — 28.6% — that would be subject to taxes and a penalty.”

Although you generally cannot avoid paying income taxes on non-qualified withdrawals, there are some exceptions to the 529 withdrawal penalty of 10%, she said. Those include if the beneficiary has passed away or become disabled, received a tax-free scholarship and if they received educational assistance through a qualifying employer program. Exceptions also include if the beneficiary is attending a U.S. military academy or if the funds are used to claim another educational tax benefit, such as the American Opportunity Tax Credit, Lifetime Learning Credit or the Tuition and Fees Deduction.

“Keep in mind that if your child gets a scholarship, you can withdraw up to the amount of the benefit that your child received to avoid the penalty,” Hards said. “Withdrawals in the excess of that amount will be subject to the penalty.”

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This story was originally published on May 25, 2022.

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