Q: I recently graduated college and have money left in my 529 plan. I would love to use the funds to help relieve some of my debt. What will the penalty be for withdrawing funds for this purpose? —Stephen, San Francisco
A: You're right to assume a penalty. While you can withdraw money from a 529 college savings plan tax free for qualified higher-ed expenses like tuition, fees and books, you'll be dinged if you use the funds for other purposes. You will have to report the amount distributed as taxable income next April—and will therefore owe tax on it at your ordinary rate—plus you'll pay an additional 10% federal penalty tax on your account's earnings. (By the way, if for some reason your debt is student loans, you're not off the hook; the IRS doesn't consider them a qualified higher education expense.)
There is one out: If you’re a recent graduate—as in, you’ve graduated in the same calendar year as when you plan to make the withdrawal—you can still take out funds tax free for qualified education expenses. So, if you paid out-of-pocket for books your spring semester, and haven’t already taken a 529 distribution to cover that expense, you can withdraw an equal amount from your account anytime during the rest of that year tax free even though you’re no longer a student, says Joe Hurley, founder of SavingforCollege.com and a certified public accountant. Keep in mind that, while you don't need any evidence to make the withdrawal, "you just need to have proof available in case of an audit."
If you still have money left in your 529 after that, look at any scholarships you received during your college career, says Hurley. The IRS doesn't want to punish people for saving up for expected tuition that ended up being paid for with scholarships. So if you can attribute your leftover balance to those scholarships, the 10% penalty on non-qualified distributions is waived. The IRS does not state whether the distribution and scholarship have to occur in the same calendar year when applying for the waiver, but Hurley says most tax experts believe it does not need to match up. He suggests tracking the total amount of scholarship aid you received during college and using that amount to justify having the penalty waived.
Can't use that workaround? Empty the account now while you’re still likely to be in a lower income tax bracket, says Hurley. If you wait a few more years, you could move up to a higher tax bracket and lose more of those funds to the IRS. Or, if you think you may want to go back to school at some point, your best bet will be to sit on the funds.