How Tax-Free Distribution on a 529 Plan Works

When you become a parent, you begin thinking about everything in a new light. Suddenly, electrical outlets and table corners are potential safety hazards, talking about highchairs and car seats is interesting. The quality of schools in your neighborhood starts to matter to you, and providing for your little one’s future becomes a top priority. That’s why you’re thinking of opening an NC 529 Account.

This tax-advantaged savings plan allows you to invest now for your child’s education, with the promise of tax-free growth and tax-free withdrawals for qualified education expenses when the time comes. But how exactly does the tax-free distribution on a 529 plan work, and what do you need to know to stay compliant with the tax code?

How Are 529 Plans Taxed?

529 plans, such as the NC 529 Plan, were specifically designed to allow families to save for education expenses. You create an account for a child, grandchild, or yourself and contribute money to the account. As an added perk, other family members, friends, or even employers can also contribute funds as gifts. 529 contributions aren’t tax-deductible on your federal income tax return, but you can choose how you want the money to be invested, and the earnings grow tax-free until your child needs them for qualified K–12 or college expenses.

When Can I Take Distributions From My Plan?

Ideally, your account will grow for a number of years, so your child will have enough money to pay for their qualified college expenses. In reality, you can withdraw funds at any time. There are no age restrictions for when you can take a tax-free qualified distribution on a 529 account. So, you can use the money to pay for your child’s undergraduate degree, graduate program, or even K–12 school tuition.

As long as you use the money for qualified education expenses, the distributions will be non-taxable. If, however, you use the funds for anything else, you’ll have to pay a 10% penalty on the earnings plus federal and state taxes. As noted in Forbes, “A 10% penalty may not sound like much, but combined with taxes, it can significantly cut into your net withdrawal amount.”

What Are Qualified Education Expenses?

The list of qualified education expenses has grown in recent years and covers much more than college tuition. You can use NC 529 funds to pay for college fees, room and board, books, and technology (like a computer and internet service). If your child chooses not to attend a traditional two-year or four-year college, your NC 529 Account will cover expenses for career/technical school or an apprenticeship program. You may be surprised to learn that up to $10,000 per year can be used for K–12 tuition at a public or private school or that you can buy special needs equipment or pay some student loan debts with your NC 529 funds.

Unfortunately, not all education-related expenses can be paid for with a tax-free distribution from your NC 529 Account. Things like transportation and insurance aren’t covered, nor are fees for clubs or activities. Before you spend money from your NC 529 Account on a questionable item, be sure to ask your plan provider if it’s acceptable.

Do I Report 529 Distributions as Income on My Tax Return?

The short answer is “No.” As long as your withdrawals are used for qualified education expenses, you don’t need to report them on your tax return, and you won’t owe any taxes on the earnings.

It’s possible that your 529 plan provider will send you a 1099-Q form that shows your annual distributions. You don’t need to submit the form with your tax return, but it’s a good idea to keep it with your records in case you’re ever audited. On that subject, it’s also important to keep detailed notes about how you spent your 529 funds, so you can prove that your withdrawals were used only for qualified education expenses.

If you do take a non-qualified withdrawal, either you, as the account owner, or your child as the beneficiary, will need to report a taxable 529 plan distribution as income on the appropriate tax return. As we mentioned above, there is a 10% penalty and taxes on the earnings. Consult a financial advisor to determine the best solution for your financial situation.

You should consult with your tax advisor with any questions you may have about how a non-qualified withdrawal will affect you.

How Do I Get Started?

If you’re ready to take advantage of all these 529 tax benefits and start saving for your child’s future, it’s easy to open an NC 529 Account. NC 529 is administered by College Foundation, Inc., a non-profit corporation that’s been helping North Carolina families access higher education opportunities since 1955. Let us help you start preparing today for your child’s bright tomorrow!