Q: I was confused about a statement you made regarding penalties on withdrawals from 529 college savings plans. You mentioned a 10% penalty on withdrawals that aren’t used for qualified education expenses but didn’t say whether the penalty applies to the entire withdrawal or just the earnings.
If it’s just the earnings, why should I care about the penalty? Even if I don’t use the money for education, I’d still be ahead because the money had a chance to grow tax-deferred.
A: That would be a heck of a loophole, wouldn’t it? But, alas, it doesn’t exist.
It’s true that only the earnings in your 529 are subject to the penalty, not your original contributions. But you’ll also have to pay regular income taxes on any gains that you withdraw.
The combination of taxes and penalties effectively eliminates the 529 as a tax shelter for most folks unless the money is used for education â€” or unless they’re in a much lower tax bracket when they withdraw the money than they were during the years in which the gains were accrued.