Income Taxes

• Standard state and federal income tax apply when 529 plan earnings are spent on unqualified higher education costs. Earnings from 529 plans are commonly exempt from state and federal income taxation provided the funds are used to pay for qualified higher education costs. Costs like housing, meal plans and tuition are qualified costs, but the details may vary among the institution or government entity that sponsors your 529 plan.
  
  

Ineligible Expenses

• In addition to incurring income tax, using 529 funds for unqualified expenses triggers an additional tax penalty. According to the Securities and Exchange Commission, a 10 percent penalty tax is assessed on the amount of 529 funds used on ineligible expenses. The total tax penalty is likely to be substantial upon the assessment of state, federal and penalty taxes.
  
  

Transfers

• Transferring funds between 529 plans or using an out-of-state plan may trigger unexpected taxes. For example, investors who transfer New York 529 funds to an out-of-state plan are liable for any state income tax deduction investors claimed on state income tax returns. The Financial Industry Regulatory Authority recommends carefully examining all the literature and information pertaining to your plan to guard against potentially costly 529 plan transfers.
  
  

Financial Aid

• Although not a direct penalty, using a 529 plan to finance the cost of education may result in decreased financial aid from both school and government sources. Investing in a 529 plan is commonly regarded as a parental asset and may lower the total value of any aid package based on financial need. However, 529 plans do not impact scholarships, grants and other aid not calculated on financial need. According to the SEC, 529 plans factor into what the family of a student is able to contribute toward education costs.
  
  

Plan Expenses

• Like most other investment vehicles, 529 plans may be subject to expenses in managing the assets in your particular plan. The SEC cites administrative, enrollment and maintenance fees as the most common types of fees for 529 plans. Like direct penalties, plan expenses lower the overall return on your investment and you are advised to thoroughly examine the fee schedule associated with your particular plan. According to the SEC, plan fees are especially prevalent if you invest in a 529 plan through a broker.