529 Plan Penalty Exceptions: When the 10% Tax Is Waived

The 10% additional tax on a 529 plan withdrawal is waived in a short list of situations spelled out in federal law: the beneficiary dies or becomes disabled, receives a tax-free scholarship or similar aid, attends a U.S. military academy, or has expenses that were used to claim an education tax credit. A separate provision added by SECURE 2.0 lets leftover funds roll into the beneficiary’s Roth IRA without penalty, and a refunded tuition payment can be recontributed within 60 days. These are the core 529 plan penalty exceptions. In every one of them, the earnings portion of the withdrawal is still taxed as ordinary income; only the extra 10% surcharge disappears.

What the 10% Tax Applies To

A 529 distribution has two parts: your contributions (basis) and the investment earnings that grew tax-free inside the account. When money comes out for anything other than qualified education expenses, only the earnings side has tax consequences. Those earnings get added to taxable income for the year, and the IRS adds a 10% additional tax on top.1Office of the Law Revision Counsel. 26 U.S. Code 529 – Qualified Tuition Programs The exceptions below remove that 10% surcharge. They do not remove the income tax on earnings.2Office of the Law Revision Counsel. 26 U.S. Code 530 – Coverdell Education Savings Accounts

Death of the Beneficiary

If the designated beneficiary dies, distributions paid to the beneficiary’s estate or to a successor beneficiary are exempt from the 10% additional tax.3Office of the Law Revision Counsel. 26 U.S. Code 530 – Coverdell Education Savings Accounts – Section: (d)(4) The earnings portion is still ordinary income to whoever receives the money.

Disability of the Beneficiary

The same waiver applies when the beneficiary becomes disabled. Federal law sets a high bar: an inability to engage in any substantial gainful activity because of a medically determinable physical or mental condition expected to result in death or to last indefinitely.4Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: (m)(7) A temporary injury, even a serious one, does not qualify. You will need physician documentation showing the condition meets that standard.

Tax-Free Scholarships and Similar Aid

When the beneficiary receives a tax-free scholarship, Pell Grant, employer-provided educational assistance, or similar award, the account holder can withdraw up to the amount of that award without the 10% penalty.5Office of the Law Revision Counsel. 26 U.S. Code 530 – Coverdell Education Savings Accounts – Section: (d)(4)(B) The waiver is dollar-for-dollar. A $12,000 scholarship supports a $12,000 penalty-free withdrawal. Anything above that faces the standard 10% tax on the excess earnings.

Take the distribution in the same tax year the award was received so the connection is clear, and hold on to the award letters. The earnings inside the penalty-free withdrawal remain taxable income.

U.S. Military Academy Appointments

If the beneficiary is appointed to a federal service academy, the government covers tuition, room, and board. Federal law waives the 10% penalty on 529 distributions up to the cost of advanced education at the academy, as determined by the relevant military department.6Internal Revenue Service. Instructions for Form 5329 – Section: Additional Tax on Certain Distributions From Education Accounts Eligible institutions include the U.S. Military Academy at West Point, the Naval Academy, the Air Force Academy, the Coast Guard Academy, and the Merchant Marine Academy.

The cap is the academy’s official cost figure. Anything above it is a standard non-qualified distribution with the 10% penalty back in play on the excess earnings. Many families in this situation change the beneficiary to a sibling instead of pulling the money out.

Expenses Used for an Education Tax Credit

You cannot use the same tuition dollars to justify both a tax credit and a tax-free 529 distribution.7Office of the Law Revision Counsel. 26 U.S. Code 529 – Qualified Tuition Programs – Section: (c)(3)(B)(v) If you claim the American Opportunity Tax Credit (worth up to $2,500 per eligible student for the first four years of higher education) or the Lifetime Learning Credit on $4,000 of tuition, those $4,000 cannot also count as qualified 529 expenses.8Internal Revenue Service. American Opportunity Tax Credit

The overlap makes part of your 529 withdrawal taxable. But the 10% penalty is waived on the portion made taxable solely because the underlying expenses were used for a credit.9Internal Revenue Service. Publication 970 (2025), Tax Benefits for Education The math: total qualified education expenses, minus tax-free scholarships or grants, minus expenses claimed for the AOTC or Lifetime Learning Credit. What remains supports a fully tax-free 529 distribution. Anything above that figure is a non-qualified distribution, and thanks to this exception the earnings owe income tax but not the extra 10%.

Rollover to a Roth IRA

The SECURE 2.0 Act lets leftover 529 money move into a Roth IRA for the beneficiary, avoiding the 10% penalty entirely. The conditions are narrow.

Annual rollovers are capped at the prevailing Roth IRA contribution limit, which for 2026 is $7,500 (or $8,600 for those age 50 and older).11Internal Revenue Service. Retirement Topics – IRA Contribution Limits The Roth limit is normally the lesser of that cap or the individual’s taxable compensation for the year, and IRS Publication 590-A applies the same framework to 529 rollovers. The beneficiary generally needs earned income at least equal to the amount rolled over.10Internal Revenue Service. Publication 590-A (2025), Contributions to Individual Retirement Arrangements (IRAs) At $7,500 per year, filling the $35,000 lifetime cap takes about five years.

This works cleanly for accounts opened when the child was young. If you opened the 529 during high school, the 15-year clock likely will not have run by the time the money is left over.

Tuition Refunds Recontributed Within 60 Days

If a student drops a course or leaves school and the institution refunds tuition that a 529 distribution had covered, that distribution suddenly looks non-qualified. The fix is to recontribute the refunded amount to a 529 plan within 60 days of receiving it.12Internal Revenue Service. Notice 2018-58: Guidance on Recontributions, Rollovers and Qualified Higher Education Expenses Under Section 529 The recontribution can go into any 529 for the same beneficiary, cannot exceed the refund, and does not count against contribution limits. Miss the 60-day window and there is no recourse. This deadline catches families off guard because refund checks often arrive during an already chaotic stretch.

Rollovers and Beneficiary Changes as Alternatives

Before invoking any exception, consider whether you need a distribution at all. You can roll 529 funds into another 529 plan, or change the beneficiary to a qualifying family member, without triggering income tax or the 10% penalty. Qualifying family members include the beneficiary’s spouse, children, siblings, parents, grandparents, nieces, nephews, aunts, uncles, in-laws, and first cousins, among others.

For same-beneficiary rollovers between 529 plans, only one rollover is permitted in any 12-month period. Rollovers that also change the beneficiary do not carry that limit.

What Is Not a Penalty Exception (Because It Is Already Qualified)

Some uses people call “exceptions” are really qualified expenses that never trigger the 10% tax in the first place. They do not go on Form 5329 at all.

None of the earnings on these distributions face income tax or the 10% penalty.

Reporting the Exception on Form 5329

Your 529 administrator sends a Form 1099-Q for any distribution during the year. The form’s Box 7 codes flag death (code 5) and disability (code 4) distributions, but the 1099-Q by itself does not claim the exception.16Internal Revenue Service. Instructions for Form 1099-Q To actually waive the 10% additional tax, file Form 5329 with your return and use Part II. Line 6 is where you enter the amount qualifying for an exception — death, disability, scholarship, military academy, or education tax credit overlap.17Internal Revenue Service. Instructions for Form 5329 – Section: Part II Skip the form and the IRS will assess the penalty automatically based on the 1099-Q; you will then have to answer a notice to reverse it.

Have the supporting documents ready even though you do not attach them: scholarship award letters, physician certification of disability, academy appointment paperwork, and your credit-coordination calculations.

Watch for State Tax Recapture

A federal penalty waiver does not shield you from state consequences. States that offer an income tax deduction or credit for 529 contributions typically have recapture rules: a non-qualified distribution adds previously deducted contributions back into state taxable income. Some states carve out distributions caused by death, disability, or scholarships; others do not. Check the rules in your state before taking any distribution that is not straightforwardly for qualified education expenses.