The beneficiary is responsible for any tax due on a distribution from the program. A refund of earnings not used to pay qualified higher educational expenses of the beneficiary is subject to a penalty unless it meets one of the conditions listed below under Allowed uses of distributions.

Taxation of distributions. Generally, the beneficiary must pay tax on any earnings on amounts paid or contributed to a qualified state tuition program when those earnings are distributed. The beneficiary does not have to pay tax on the earnings if they are not taxable because of some other provision of the law. There is no tax on the part of the distribution representing the amount paid or contributed to the program. The part representing the amount paid or contributed to the program is the part of the distribution which bears the same ratio to the distribution as the payment or contribution bears to the total balance in the program.

Allowed uses of distributions. Generally, distributions must be used to pay the qualified higher education expenses (defined earlier) of the beneficiary.

Penalty. There is a penalty on any refund of earnings that does not meet at least one of the following conditions.

1. The refunded earnings are used to pay qualified higher educational expenses of the beneficiary.
2. The refund of earnings is made because of the death or disability of the beneficiary.
3. The refund of earnings is made because the beneficiary received a scholarship, a veterans educational assistance allowance, or another nontaxable payment (other than a gift, bequest, or inheritance) for educational expenses. This only applies to the part of the refund that is not more than the scholarship, allowance, or other payment.

In-kind distributions. Any in-kind distribution (such as a waiver of tuition) furnished to a beneficiary under a qualified state tuition program is considered a distribution to the beneficiary.

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