There are exceptions to the 10 percent-penalty rule, such as if the account beneficiary dies or becomes disabled. If your child receives a tax-free scholarship or grant, or if he or she gets funds through a veterans or employer-provided educational assistance program, you can also qualify for an exemption from the 10 percent penalty. And the penalty will be waived if the child attends a military academy.
The penalty is also avoidable in certain cases related to the American Opportunity tax credit or Lifetime Learning tax credit. If you used some of your tuition and textbook expenses to qualify for the American Opportunity credit, for example, and therefore couldn’t use those expenses for a qualified distribution from a 529 plan, you can take a nonqualified distribution and avoid the 10 percent tax penalty on the portion that is attributable to the tuition and textbook expenses used to justify the tax credit.
In all of these cases, you will still pay federal income tax (and possibly state income tax) on the earnings portion of the distribution. So while you can pull unused money out of a 529 account for nonqualified expenses, it’s not optimal, especially if you don’t qualify for one of the exceptions to the 10 percent penalty.
There are other options for the unused 529 funds. You can use up to $10,000 of 529 funds per beneficiary for student loan payments. That means that a family could use $10,000 from a 529 to pay down one child’s student loan debts and another $10,000 from the same account to pay down their sibling’s loans. But you can’t use $10,000 from one 529 and $10,000 from another to pay down student debt for one child. Check your state’s laws to see whether the distribution is subject to state income tax.
