Sounds like your 529's are a lot more restrictive than Canadian RESP's. When I looked into it the following are the "penalties" on RESP's if your kid does not go to one of the 4000+ approved schools (3/4 of them outside of Canada, it is highly flexible):
1) Have to wait until the kid is 21 and the plan is at least 10 years old, or deceased. (If you created the plan when the kid was 15, you need to wait until kid is age 25).
2) Can withdraw your original contributions with zero penalty.
3) The tax rebate / matching money (which was 20% of the dollars put in, up to a limit), goes back to the government if not spent on education-- that's fair.
4) The Accumulated income on both the match and your contributions, can be rolled into your retirement account, (if you have room), OR you can take it as cash. The Government takes 20% of it (their share of the growth of the money that they provided through the matching) and you pay income tax on the rest.
. . . .
For states that offer a tax benefit on 529's is your "penalty" in the event the child does not go to school so much different?
I really don't think 529s are that different.
1. We don't have a time limit. But we can change the beneficiary over to someone else with no tax consequences. So if DD doesn't need all that we have saved for her, I can redesignate her brother as the beneficiary -- or even myself, if I want to go take some college classes for fun in retirement.
2. This is true for 529s as well. The "penalty" is limited to the growth in the account.
3. We don't have matching money. But the consequence of spending the money on non-educational expenses are (i) instead of taking out the money tax-free, you pay taxes on the growth in the account at your regular income tax rate, and (ii) you pay a 10% penalty on that same figure. That sounds fairly similar to your losing the 20% benefit the gov't provided (but would obviously be higher or lower depending on the individual's tax bracket). Note also the penalty (but not the tax) is waived if the beneficiary dies/becomes disabled, receives a scholarship, or attends a military academy.
4. We do not have the option to roll it into a retirement account, which would be awesome. Then again, our retirement accounts don't have lifetime maximums but do have annual contribution limits; I imagine allowing rollovers from a 529 into an IRA would trigger a lot of 529 contributions by the high-income folks to circumvent the annual 401(k)/IRA contribution caps.* However, the "take it in cash" option sounds very similar, as per 3 above.
I do not know what the individual state plans require, but I imagine they follow the same rules as the IRS, so the tax hit would be federal + state. Which makes sense, as in those states you get a state tax deduction in the year you contribute, so it's only fair you pay that back if you don't use the money for its intended purpose.
I think all of the hand-wringing about 529s tends to be overstated if you are in a state with a good plan. I get $10K in state tax deductions every year, plus that money grows tax-free (federal and state) in a low-fee index fund, plus my kids can then take out that money tax-free (federal and state) for a huge swath of educational expenses, including their rent and dining hall and laptop and such while they are at college. That is pretty close to the "triple tax-free" benefit that you get from an HSA (just missing the federal deduction for the initial contributions). Yet everyone here totally raves about HSAs, while 529s are largely scorned as too limited. I don't get it.
*There are caps on total $$ in a 529 between @$235-500K, but that's a significant chunk of change compared to the $5500/yr IRA limit.