A taxpayer contributes $5,000 to a 529 Plan in Year 1. The state offers a tax deduction. In Year 3, the account is worth $7,000. The taxpayer withdraws $7,000 for non-qualified expenses. What is the federal tax consequence?

Answer options:

$7,000 is taxable income.

$2,000 is taxable income + 10% penalty.

$2,000 is taxable income; no penalty.

How to approach this question

529 Rule: Principal comes back tax-free. Earnings are Tax-Free IF qualified. If Non-Qualified -> Earnings are Taxed + 10% Penalty.

Full Answer

B.$2,000 is taxable income + 10% penalty.✓ Correct

$2,000 is taxable income + 10% penalty.

IRC §529. The earnings portion of a non-qualified distribution is included in gross income and subject to a 10% penalty. The return of principal is tax-free.

Common mistakes

Taxing the entire distribution.

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