Restricted Use of Plan Assets
Now that you understand the ownership structure and tax treatment of 529 plans, let's examine the rules that govern how plan assets can be used, and what happens when they aren't used for education.
Qualified vs. Non-Qualified Use
529 plan assets must be used for qualified education expenses to receive tax-free treatment. When funds are used for non-qualified purposes:
- Earnings are subject to ordinary income tax
- Plus a 10% federal penalty on the earnings portion
- The contribution portion is always returned tax-free (it was already taxed when contributed)
Think of it this way: The money you put in was already taxed, so you always get that back. The penalty and taxes only hit the growth (earnings) your account generated.
Exam Tip: Gotchas
- The 10% penalty applies to EARNINGS only. Contributions come back tax-free regardless of how the money is used.
Exceptions to the 10% Penalty
The 10% penalty is waived if:
| Exception | Details |
|---|---|
| Scholarship | Beneficiary receives a tax-free scholarship; penalty-free withdrawal up to the scholarship amount (earnings still taxed as income) |
| Military academy | Beneficiary attends a U.S. military academy (West Point, Annapolis, etc.) |
| Death | Beneficiary dies |
| Disability | Beneficiary becomes disabled |
Important: Even when the penalty is waived, the earnings portion of a non-qualified withdrawal is still subject to ordinary income tax (except in the case of death or disability, where different rules may apply).
Exam Tip: Gotchas
- Scholarship exception waives the PENALTY but not the INCOME TAX on earnings. The beneficiary still owes ordinary income tax on the earnings portion of any non-qualified withdrawal.
Rollover to Roth IRA (SECURE 2.0 Act)
Starting in 2024, unused 529 funds can be rolled over to a Roth IRA for the beneficiary, giving families an option for leftover 529 money.
Requirements:
| Rule | Requirement |
|---|---|
| Account age | 529 plan must have been open for at least 15 years |
| Contribution seasoning | Contributions made in the last 5 years (and their earnings) are NOT eligible for rollover |
| Annual limit | Subject to annual Roth IRA contribution limits ($7,500 in 2026; $8,600 for age 50+) |
| Lifetime cap | Maximum of $35,000 in total lifetime rollovers per beneficiary |
| Roth IRA owner | Must be the 529 plan beneficiary (not the account owner) |
| Transfer method | Must be a direct trustee-to-trustee transfer |
| Income limits | Roth IRA income limits do NOT apply to 529 rollovers |
Exam Tip: Gotchas
- The 529-to-Roth IRA rollover has multiple conditions that must ALL be met. 15-year account age, 5-year contribution seasoning, annual Roth limits, and a $35,000 lifetime cap. The exam may test any of these requirements individually.