How to Avoid The 529 Withdrawal Tax Penalty

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There are typically no withdrawal penalties associated with leaving leftover funds in a 529 plan after college. In fact, 529 plans allow you to withdraw up to $10,000 per year, per student.

But still, the earnings portion of a non-qualified 529 plan distribution can be subject to income tax and a 10% penalty for 529 withdrawal.

Keep reading to learn more about what a 529 plan withdrawal penalty is, which 529 withdrawal penalty exceptions exist, and a few other college financing options for students and parents without 529 plans.

What Is a 529 Plan?

A 529 plan is a college savings investment account that comes with unique tax benefits if it’s used to pay for qualified education expenses. It can help cover the costs of a beneficiary attending college, K-12 school, an apprenticeship program, or even to pay back student loans.

When someone uses a 529 plan to save up for college, the funds generally have little impact on their ability to receive financial aid.

In addition, there are several other benefits to using a 529 plan:

  • Funds in the account are invested and grow over time.
  • Depending on the type of 529 plan, beneficiaries can prepay for college in advance to lock in current tuition prices before they go up.
  • 529 college savings accounts are listed as assets when the beneficiary applies for Federal Student Aid.
  • Certain 529 plans let beneficiaries deduct their contributions on their state income taxes.
  • 529 plan contributions can be considered “completed gifts” to the beneficiary, allowing families to use them as estate planning vehicles. For 2023, the annual gift tax exclusion can be applied up to $17,000 per donor, per beneficiary and in 2022 the annual exclusion was $16,000.

What Are Qualified 529 Plan Distributions?

Let’s start with the education expenses that are considered qualified within a 529 plan:

  • Tuition and associated fees
  • Room and board (if the student is enrolled at least half-time)
  • Books
  • Technological equipment and computers
  • Equipment for special needs
  • Student loan payments
  • Up to $10,000 per year, per beneficiary in eligible K-12 expenses
  • Apprenticeship program tuition and fees
  • Up to $10,000 in K-12 tuition expenses (per year, per beneficiary)

What Are Non-Qualified 529 Plan Distributions?

Non-qualified 529 plan distributions describe any portion of a plan withdrawal in which the funds were not used to pay for qualified education expenses like the ones listed above.

As such, here are some of the education expenses that are considered non-qualified:

  • Costs associated with transportation
  • Costs associated with college application and testing
  • Costs associated with extracurricular activities
  • Health insurance costs
  • Any cost that doesn’t fall under the umbrella of the qualified education expenses listed above

Are Distributions Taxable?


Generally, contributions can be withdrawn tax-free because taxes are paid at the time of contribution. The earnings portion (the money earned from investments) of a non-qualified 529 program plan distribution could be subject to a 10% federal income tax penalty on top of any associated income taxes that may be due. It would be taxable to whomever received the payment, whether that’s the account owner or the designated beneficiary.

If the non-qualified distribution is not paid out to either the designated beneficiary or the eligible educational institution, it’s assumed to have been given to the account owner who will be subject to the 10% withdrawal penalty and tax.

What Is a 529 Early Withdrawal Penalty?

A 529 early withdrawal penalty occurs when investment gains are withdrawn from a 529 account before the beneficiary incurs any qualifying expenses, or if they withdraw funds for any of the non-qualified reasons listed above.

When this happens, the IRS can assess a steep early withdrawal penalty of 10%.

In California, an extra 2.5% state income tax penalty is imposed on the earnings portion of non-qualified 529 plan distributions.

Can I Make a Withdrawal From 529 Without Penalty?

In certain cases, it’s possible to execute a withdrawal from 529 without penalty, such as if:

  • A plan beneficiary passes away, becomes disabled or decides to attend a U.S. Military Academy.
  • A family must pay income tax on a portion of their 529 withdrawal due to their claiming the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC).
  • A plan beneficiary receives certain other types of educational assistance, such as a scholarship exception.

529 Withdrawal Penalty Exceptions

Here are a couple of circumstances in which a 529 withdrawal penalty may not apply to a non-qualified distribution.

Scholarship

It may come as a surprise to learn that the 10% 529 early withdrawal penalty doesn’t apply when a beneficiary no longer needs to use their 529 funds because they received a scholarship.

This particular 529 withdrawal penalty exception allows funds to be withdrawn from the 529 plan without penalty up to the amount of the scholarship itself.

While this is one way to avoid a penalty for 529 withdrawal, account owners will still owe taxes on the earnings after the initiation of the withdrawal if they are used on non-qualified expenses.

Death or Disability of Account Beneficiary

If the 529 account beneficiary passes away, the withdrawal fees are generally waived.

The additional fee is also generally waived in the event that the designated beneficiary becomes disabled. According to the IRS, someone is considered disabled if they are able to prove that they are unable to participate in any significant gainful activity due to a physical or mental condition.

Beneficiary Enrolls in a US Service Academy

If the designated beneficiary enrolls in a U.S. service academy, such as the United States Naval Academy at Annapolis, the withdrawal fee may be waived. Note that the exception to the withdrawal fee only applies so long as the distribution amount does not exceed the cost of attendance as defined by the IRS.

Time Limit

There’s a decent amount of debate around the timing of a 529 plan distribution when it’s based on a scholarship. There are no clear instructions from Congress or the IRS, which means tax professionals and other financial experts may vary in their guidance. If you have specific questions, consider consulting with a tax professional who can provide a personalized recommendation.

What if My Child Doesn’t Go to College?

If you’re a parent who’s saving for your child’s college tuition and they don’t decide to go to college, there are certain specifications and limitations around what else the 529 funds can be used for.

For example, in some states, 529 funds can be used to cover K-12 expenses or professional schools.

That said, if the beneficiary decides to take a gap year to travel or join the armed forces, the funds can’t be withdrawn for personal use by the parents for something like a major renovation.

Still, there are a few ways to take advantage of 529 savings when the intended dependent doesn’t want to attend a college or university:

Changing the Beneficiary

In instances where the account owner has more than one dependent, they may be able to change the beneficiary of the existing 529 plan from one child to another. All they need to do is fill out the associated paperwork, which can typically be found on the 529 plan provider’s website, or give them a call and have them send it in the mail.

Apprenticeships

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act expanded the scope of qualified educational expenses for 529 plans to include student loan repayment and registered apprenticeships.

If an apprenticeship is registered and certified with the U.S. Secretary of Labor  , it is considered a qualified higher education expense and, as such, associated program fees, supplies, books, and equipment may be considered qualified higher education expenses as well.

Repay Student Loans

As briefly mentioned above, student loan repayment is now included as a qualified education expense for 529 plans. Under the SECURE Act, it is possible to use a lifetime maximum of $10,000 from a 529 plan to pay down student loan debt. This money can be used to repay student loan debt that belongs to the 529 plan account holder, their spouse, children, or grandchildren.

Other College Financing Options

If you or a dependent missed the boat on setting aside funds in a 529 college savings plan, there are still plenty of options to secure financial support.

If you’re looking for another way to pay for your child’s college education, you might consider:

  • Federal student loans. There are many types of federal student loans funded by the federal government and, in order to qualify, you must fill out the Free Application for Federal Student Aid (FAFSA®) form every year you want to receive federal student loans. Federal loans offer an array of flexible payment options, the ability to earn student loan forgiveness, and the option to defer payments or put the loan into forbearance.
  • Parent Plus loans. A Parent Plus Loan is a federally funded student loan that can be taken out by parents to help their undergraduate dependents pay for college. There are no annual or lifetime borrowing limits and, with the Parent Plus Loan Forgiveness Program, borrowers are eligible for an income-contingent repayment plan or relief from the Public Service Loan Forgiveness program. There is no federal program that allows for parents to transfer a parent plus loan to the student.
  • Private student loans. A private loan for students can help cover the cost of a college education based on the borrower’s credit score and can be obtained from a variety of private lenders.

When you opt for a private student loan with SoFi, you can check your rate instantly, apply in minutes, and there are no hidden fees. While private student loans can help fill funding gaps for students who are paying for college, they don’t always offer the same borrower benefits or protections as federal student loans, such as the option to pursue Public Service Loan Forgiveness or deferment options. For this reason, they are generally borrowed only after all sources of financing have been thoroughly reviewed.

The Takeaway

A 529 plan is a college savings investment account that comes with unique tax benefits if it’s used to pay for qualified education expenses. Qualified expenses include tuition, fees, school supplies, and room and board. Non-qualified expenses include health insurance, extra-curricular activities, and fees for applications and testing — to name a few.

When someone withdraws funds from their 529 plan for non-qualified expenses, they are subject to a 10% early withdrawal penalty. In some cases, though, there are 529 withdrawal penalty exceptions, including when a plan beneficiary passes away, claims a specific tax credit, or receives a scholarship.

In cases where a dependent decides not to go to college, 529 plan account owners have the option to change the plan beneficiary to another dependent, use the funds for a dependent’s apprenticeship, or cover K-12 expenses.

Other college financing options include federal student loans, Parent Plus Loans, and private student loans.

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.


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IRA Deduction and Contribution Limits For Taxes: Everything You Need Need to Know

IRA Deduction and Contribution Limits For Taxes: Everything You Need Need to Know

Broadly speaking, individual retirement accounts, or IRAs, offer some sort of tax benefit — either during the year that contributions are made or when distributions take place after retiring. But not all retirement accounts are taxed the same.

With a traditional IRA, it’s possible for certain individuals to both invest for their future and reduce their present tax liability. For tax year 2023, the maximum IRA deduction is $6,500 for individuals younger than 50, and $7,500 for those 50 and older. For tax year 2024, the maximum IRA deduction is $7,000 for people younger than 50, and $8,000 for those 50 and older.

To maximize deductions in a given year, the first step is understanding how IRA tax deductions work. A good place to start is learning the differences between common retirement accounts — and their taxation. And since each financial situation is different, an individual may also want to speak with a tax professional about their specific situation.

Read on to learn more about IRA tax deductions, including how both traditional and Roth IRA accounts are taxed in the U.S.

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First, here’s a quick refresher on tax deductions for income taxes — the tax owed/paid on a person’s paycheck, bonuses, tips, and any other wages earned through work. “Taxable income” also includes interest earned on bank accounts and some types of investments.

Tax deductions are subtracted from a person’s total taxable income. After deductions, taxes are paid on the amount of taxable income that remains. Eligible deductions can allow qualifying individuals to reduce their overall tax liability to the Internal Revenue Service (IRS).

For example, Person X earns $70,000 per year. They qualify for a total of $10,000 in income tax deductions. When calculating their income tax liability, the allowable deductions would be subtracted from their income — leaving $60,000 in taxable income. Person X then would need to pay income taxes on the remaining $60,000 — not the $70,000 in income that they originally earned.

For the 2023 tax year, 22% is the highest federal income tax rate for a person earning $70,000. By deducting $10,000 from their taxable income, they are able to lower their federal total tax bill by $2,200, which is 22% of the $10,000 deduction. (There may be additional state income tax deductions.)

tax deduction is not the same as a tax credit. Tax credits provide a dollar-for-dollar reduction on a person’s actual tax bill — not their taxable income. For example, a $3,000 tax credit would eliminate $3,000 in taxes owed.

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Traditional IRA tax deductions are quite simple. If a qualifying individual under age 50 contributes the maximum allowed to a traditional IRA in a year — $6,500 for the 2023 tax year and $7,000 for the 2023 tax year — they can deduct the full amount of their contribution from their taxable income.

That said, you are not eligible to claim your IRA deduction if you are:

  • Single and covered by a workplace retirement account and your modified adjusted gross income (MAGI) is more than $83,000 for tax year 2023 ($87,000 or more for tax year 2024)
  • Married filing jointly and covered by a work 401(k) plan and your MAGI is more than $136,000 for tax year 2023 ( more than $143,000 for tax year 2024)
  • Married, only your spouse is covered by a work 401(k) plan, and your MAGI is more than $228,000 for tax year 2023 ($240,000 or more for tax year 2024).

It’s worth noting that you may claim a partial deduction, depending on your income if you are:

  • Single and covered by a workplace retirement account and your adjusted gross income is more than $73,000 and less than $83,000 for tax year 2023 (more than $77,000 and less than $87,000 for tax year 2024)
  • Married filing jointly and covered by a work 401(k) plan and your MAGI is more than $116,000 and less than $136,000 for tax year 2023 (more than $123,000 and less than $143,000 for tax year 2024)
  • Married, only your spouse is covered by a work 401(k) plan, and your MAGI is more than $218,000 and less than $228,000 for tax year 2023 (more than $230,000 and less than $240,000 for tax year 2024).

401(k), 403(b), and other non-Roth workplace retirement plans work in a similar way (contributions to Roth IRAs are not tax deductible). For the 2023 tax year, the contribution maximum for a 401(k) is $22,500 with an additional $7,500 catchup contribution for employees 50 and older. For tax year 2024, the contribution maximum is $23,000 with an additional $7,500 catchup contribution for employees 50 and older. A person under 50 who contributes the full amount in 2023 could then deduct $22,500 from their taxable income ($23,000 in 2024), potentially lowering their tax bracket.

One common source of confusion: The tax deduction for an IRA will reduce the amount a person owes in federal and state income taxes, but will not circumvent payroll taxes, which fund Social Security and Medicare. Also known as Federal Insurance Contributions Act (FICA) taxes, these are assessed on a person’s gross income. Both the employer and the employee pay FICA taxes at a rate of 7.65% each.

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Traditional IRA, 401(k), and other non-Roth retirement accounts are deemed “tax-deferred.” Money that enters into one of these accounts is deducted from an eligible person’s total income tax bill. In this way, qualifying individuals do not pay income taxes on that invested income until later.

Because these taxes are simply deferred until a later time, the money in the account is usually taxed when it’s withdrawn.

Here’s an example of this: Having reached retirement age, a person chooses to withdraw $30,000 per year from a traditional IRA plan. As far as the IRS is concerned, this withdrawal is taxable income. The traditional IRA money will be taxed as the income.

So, what’s the point of deferring taxes? Generally speaking, people may be in a higher marginal tax bracket as a working person than they are as a retired person. Therefore, the idea is to defer taxes until a time when an individual may pay proportionally less in taxes.

Tax Brackets and IRA Deductions

Income tax brackets can work in a stair-step fashion. Each bracket reveals what a person owes at that level of income. Still, when a person is “in” a certain tax bracket, they do not pay that tax rate on their entire income.

For instance, in 2023, single filers pay a 12% federal income tax rate for the income earned between $11,001 and $44,725. Then, the tax rate “steps up,” and they pay a 22% tax on the income earned that falls in the range of $44,726 and $95,375. Even if a person is a high-earner and “in” the 37% tax bracket, they still pay the lower rates on their lower levels of income.

Why is this worth noting? Because tax deductions reduce a person’s taxable income at their highest marginal rate (their highest “stair-step”). Using 2023 tax rates, a person with $70,000 in taxable income would be taxed like this:

  •    10% up to $11,000 ($59,000 remaining)
  •    12% up to $44,725 ($14,275 remaining)
  •    22% on the remaining $14,275

However, if that same person contributes the maximum to their tax-deferred retirement account, they would be taxed 22% on the top amount minus what’s deductible. In other words, they wouldn’t be taxed 22% on the full $14,275.

401(k) Withdrawals and Taxation

Now, let’s compare that with the taxation on a $30,000 withdrawal from a 401(k). Assuming 2023 income tax rates, a $12,000 withdrawal would be taxed at a 10% rate up to $11,000 and then a 12% rate for the remaining $19,000.

Taxes are assessed at a person’s “effective,” or average, tax rate. This is another reason that some folks prefer to defer their taxes until later, when they can pay a hypothetically lower effective tax rate on their withdrawals, rather than taxes at their highest marginal rate.

But, here’s why it’s not so simple: All of the above assumes that income tax rates remain the same over time. And, income tax rates (and eligible deductions) can change with federal legislation.

Still, plenty of earners opt to reduce their tax bill at their highest rate in the current year — and a tax deduction via an eligible retirement contribution can do just that.

For individual tax questions, it’s a good idea to consult a tax professional with questions about specific scenarios.

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Simply put, there are no tax deductions for Roth retirement accounts. Both Roth IRA and Roth 401(k) account contributions are not tax-deductible.

The trade-off is that Roth money is not taxed when it is withdrawn in retirement, as is the case with tax-deferred accounts like a 401(k) and traditional IRA. In fact, this is the primary difference between Roth and non-Roth retirement accounts. With Roth accounts, taxes are already paid on money that is contributed, whereas income taxes on a non-Roth 401k are deferred until later.

So, then, what are some advantages of a Roth retirement account? All retirement accounts provide an additional type of tax benefit as compared to a non-retirement investment account: There are no taxes on interest or capital gains, which is money earned via the sale of an investment.

Someone might choose a Roth over a tax-deferred retirement account because they prefer to pay the income taxes up front, instead of in retirement. For example, imagine a person who earned $30,000 this year. They pay a relatively low income tax rate, so they simply may prefer to pay the income taxes now. That way, the taxes are potentially less of a burden come retirement age.

Not everyone qualifies for a Roth IRA. There are limits to how much a person can earn. For a single filer, the ability to contribute to a Roth IRA for tax year 2023 begins to phase out when a person earns more than $138,00 ($146,000 for tax year 2024), and is completely phased out at an income level of $153,000 in 2023 ($161,000 for tax year 2024). For a person that is married and filing jointly, the phase-out begins at $218,000 in 2023 ($230,000 for tax year 2024), ending at $228,000 in 2023 ($240,000 for 2024).

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The maximum amount a person is able to deduct from their taxes by contributing to a retirement account may correspond to an account’s contribution limits.

Here’s how much money can be put into an IRA for the 2023 tax year:

  • Traditional IRA: $6,500 ($7,500 if age 50 or older), deductibility depends on whether the person is covered by a workplace retirement plan
  • 401(k): $22,500 (additional $7,500 if age 50 or older)
  • 403(b): $22,500 (additional $7,500 if age 50 or older)
  • 457(b): $22,500 (additional $7,500 if age 50 or older)
  • Thrift Savings Plan (TSP): $22,500 (additional $7,500 if age 50 or older)
  • Simple IRA or 401(K): $15,500 (additional $3,500 if age 50 or older)
  • SEP IRA: The lower of 25% of an employee’s income, or $66,000
  • Solo 401(k): Either $22,500 or up to 100% of total earned income as employee, additional opportunity to contribute as the employer


Here are the maximum contributions for the 2024 tax year:

  • Traditional IRA: $7,000 ($8,000 if age 50 or older), deductibility depends on whether the person is covered by a workplace retirement plan
  • 401(k): $23,000 (additional $7,500 if age 50 or older)
  • 403(b): $23,000 (additional $7,500 if age 50 or older)
  • 457(b): $23,000 (additional $7,500 if age 50 or older)
  • Thrift Savings Plan (TSP): $23,000 (additional $7,500 if age 50 or older)
  • SEP IRA: The lower of 25% of an employee’s income, or $69,000
  • Simple IRA or 401(K): $16,000 (additional $3,500 if age 50 or older)

The above lists are only meant as a guide and do not take into account all factors that could impact contribution or deduction limits — such as catch-up contributions. Anyone with questions about what accounts they qualify for should consult a tax professional.

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Different types of retirement accounts come with distinct tax benefits and, for eligible investors, IRA tax deductions. Opening a retirement account and contributing to certain tax-deferred accounts may affect how much a person owes in income taxes in a given year. Roth accounts may provide tax-free withdrawals later on.

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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