Here's What Happens When You Take a Non-Educational Withdrawal From a 529 Plan

When it comes to saving for college, you have options. You could invest in a regular brokerage account, which means you won't be restricted with regard to things like annual contributions, and you'll be able to take a withdrawal at any time and for any purpose without penalty. You could also fund a Roth IRA for college savings purposes and enjoy tax-free investment gains and withdrawals on your money.

But Roth IRAs limit the amount of money you can put in each year. This year, for example, you're limited to $6,500 if you're under age 50, or $7,500 if you're 50 or older.

With a 529 plan, you also get tax-free investment gains and tax-free withdrawals for educational purposes, and you can put more money into a 529 than a Roth IRA. In fact, 529 plans generally do not have annual contribution limits, though you may trigger the gift tax if you contribute a lot, so it's best to talk to an accountant or financial advisor before funding one of these accounts.

It used to be that 529 plans were only earmarked for college savings. But now, you can take a 529 plan withdrawal without penalty to pay for private elementary, middle, or high school as well.

But what if you end up having to take a non-educational withdrawal from a 529 plan? In that case, taxes and penalties could come into play, but the blow may not be as bad as you think.

When you end up with extra money in your 529 plan

Given the cost of education these days (of all kinds), having extra money in a 529 plan can be considered a very good problem to have. But you should know that if you take a 529 plan withdrawal for a non-qualified expense (meaning, an expense that isn't an approved educational expense), you'll be subject to taxes and penalties on the gains portion of your account. Those won't, however, apply to the earnings portion.

Here's how that might work. Let's say you contribute $50,000 to your 529 plan and your balance grows to $80,000 over time. Let's also assume you remove your entire $80,000 balance for non-education purposes because your child decides they don't want to go to college.

At that point, you're not taxed or penalized on the initial $50,000, because you didn't get a tax break when you put that money in. But you generally will face taxes and a 10% penalty on the $30,000 gains portion.

Penalties are waived when scholarships come into play

Generally, you should expect to face a penalty when you tap a 529 plan for non-educational purposes. But there's an exception to that rule, and it's if the beneficiary of your 529 plan receives a full scholarship to college. In that case, the aforementioned penalty is waived.

You should also know that starting next year, you'll have the option to roll unneeded 529 plan funds into a Roth IRA without penalty, in the amount of up to $35,000 per beneficiary. That, too, could help you avoid an unwanted penalty if you don't end up using all of your 529 plan balance to pay for college or other educational expenses.