When a nonqualified distribution is taken from a Sec 529 plan it is taxable to the recipient of the distribution. Distributions from a 529 plan may be paid directly to the educational institution, to the beneficiary or to the account owner. Here is where it gets messy. It is taxable to whoever’s name is on the distribution check. For example, a grandmother who is the account owner cannot take the distribution and then assign the income to the granddaughter who is the student-beneficiary. IRC Sec 529(c)(3)(A) says non-qualified distributions are to be included in the gross income of the distributee.

Of course, only the earnings included in a nonqualified distribution are taxable and the taxable earnings are subject to a 10% penalty.