Section 529 plans provide families with a powerful tax incentive to save for retirement: Tax-free growth, and tax-free withdrawals, provided the money is used for qualified education expenses. Nothing is free in this world, though, and the tax advantages of the 529 plan come at a price: There are penalties for withdrawing 529 plan contributions early or using the money for purposes not listed as qualified education expenses.
Qualified Education Expenses
For the purposes of Section 529 plans, any withdrawal to pay for college, trade or vocational-school tuition, supplies, books, and even a laptop computer for school purposes is a qualified educational expense. Room and board also counts as a qualified educational expense, provided the student is enrolled at least half time.
Because 529 plan contributions are not tax-deductible under federal income-tax rules, you don't have to pay income taxes on your own contributions. However, you will have to pay income taxes on any growth that occurred within the account between the time you made the contribution and the time you withdrew the money.
The IRS assesses a 10 percent penalty on the entire withdrawal, including your original contribution, if you take the money out early or if you do not match the withdrawal up against a qualified higher-education expense.
Before you tap the Section 529 plan for an early withdrawal or a nonqualified purpose, carefully consider other forms of capital. It may be more efficient to take money out of a taxable account, borrow from a 401(k) plan, or get a bank or personal loan. If the intended beneficiary is not going to use the money for school, you may consider changing the beneficiary to someone who is planning on going to college.