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Student Question of the Week: 529 Nonqualified Withdrawal Penalty

Student Question from Andrew S.
Course: Fundamentals of Financial Planning

Student Question:

Under “penalties and restrictions for nonqual WDs from 529 plans”, what exactly is “this additional tax” mentioned in the third paragraph? Is it talking about the penalty or the penalty and income tax?

Thanks.

Andrew


Instructor Response:

Hi Andrew!

This is a key topic and question regarding 529 Plans. So, what we are talking about there is the 10% penalty that will be assessed on nonqualified withdrawals. Essentially what happens is if you make a nonqualified withdrawal, you will be required to pay income tax on the earnings portion of that withdrawal AND will be required to pay a 10% penalty on top of that.

The purpose of the 529 Plan is tax-advantaged savings for college. When withdrawals are made for other purposes, you are going to be taxed and penalized. Because contributions to 529 Plans are “after-tax”, it is only the withdrawal attributable to earnings in the account that will be taxed and penalized.

I hope this helps to clarify. Please let me know if I can provide any further clarification.

Dan