529 withdrawals are always pro-rata contributions and earnings. That means that if you contributed $30,000 to your account over the years and it’s now worth $40,000, then your withdrawal will be 75% contributions and 25% earnings. That’s moot in the case of a qualified withdrawal, but it matters for a non-qualified one: tax and penalties will apply to the earnings portion. On the federal side, it’s taxed at the marginal rate of the person receiving the withdrawal and the penalty is 10%. So a $1,000 nonqualified withdrawal from the above account for a person in the 22% tax bracket would cost $250 x (0.22 + 0.1) = $80. Withdrawing it in the 12% bracket (i.e., sending it to your young adult) would reduce the cost by $25.

That’s on the federal side. States impose taxes on nonqualified withdrawals, too. And most states that offer a tax deduction for contributions also have a clawback provision that lets them tax a nonqualified withdrawal to reclaim the tax break that was given upfront. Such is the case here in Oregon, where (assuming all contributions were deductible), the state would charge 9% of the total withdrawal– recapturing the 9% tax break on the contribution and assessing 9% tax on the earnings.

Most of us don’t have so much in our 529s that we worry about nonqualified distributions. I know I’m more worried about how to stretch my 529 dollars over four years. But with tax season in full swing, I’m seeing a number of people getting dinged by the state for using their 529 to pay for K-12 expenses. Like many states, Oregon decoupled from federal law with respect to using 529s for K-12 expenses, meaning any withdrawal for those purposes is treated by the state as nonqualified.

Families in one of the many states that don’t offer tax breaks for K-12 have a couple of options. Coverdell ESA accounts are eligible for K-12 expenses at both the state and federal level, although there is no state tax deduction for contributions and there is an annual contribution cap. Parents wanting the higher contribution limits of a 529 should consider using an out-of-state plan such as Utah’s so as to not face tax deduction recapture. A third choice is to simply use a taxable brokerage account; however, you’d pay both federal and state capital gains taxes on the withdrawals which would negate any state tax savings.