Only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty.
Distributions are allocated between principal and earnings on a pro-rata basis. That means that your withdrawal is divided into contribution and earnings based on the following formula:
Account Contributions / Account Value x Distribution = Contribution Portion
Your contributions (the amount you originally deposited) will never incur a penalty.
What are the exceptions to the penalty rule?
The earnings portion of the withdrawal will incur income tax if the beneficiary dies or becomes disabled, if the student decides to attend a U.S. Military Academy, or if the student receives a scholarship.
All earnings on non-qualified distributions will be subject to tax as ordinary income at your tax rate.
Non-qualified withdrawals will transform your 529 plan into a taxable investment; however, some 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a low tax bracket. In addition, if you were able to deduct your original contributions on your state income tax return, you will generally have to report additional state “recapture” income.
Note that tuition and fees, books, equipment required for course enrollment (including special needs equipment), and some room and board expenses are considered qualified withdrawals. Meanwhile, transportation costs, computers (unless required by the school), and student loan repayments are considered non-qualified withdrawals.
What if you have excess funds? How do you minimize penalty?
If this is the case, you have a few options available. You can change the beneficiary to another qualifying family member who is planning to attend college, hold the funds in the account in case the beneficiary wants to attend graduate school in the future, or make yourself the beneficiary and further your own education.