Part of the confusion with 529s is the inconsistency in information about the plans:
1. The top Google hit I got when searching for "529 early withdrawal penalty"
http://wiki.fool.com/Penalty_for_Early_ ... _529_Plans
"The IRS assesses a 10 percent penalty on the entire withdrawal, including your original contribution
, if you take the money out early or if you do not match the withdrawal up against a qualified higher-education expense.
2. Referenced article in OP
http://www.bloomberg.com/news/2014-09-0 ... plans.html
"Withdrawing money for non-educational reasons means paying taxes and a 10 percent penalty. But the tax and the penalty only apply to any investment gain
. Whatever amount was put into the 529 comes back tax- and penalty-free"
3. IRS publication 970 (page 59)
"The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan" and "generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income"
So, the IRS makes it clear that you can withdraw your contributions from a 529 plan tax and penalty free but not your earnings. This makes sense and is consistent with the guidance for ROTH IRA plans. However, some websites have misleading, outdated, or just wrong information. It does not help that some appear to use contributions and earnings interchangeably. Even worse are website articles that are not dated, so you don't know if you are getting out of date information!
All of that aside, I think the lack of adoption is a combination of lack of knowledge of the plans, the lack of ability for many families to set aside yet another pot of money for things, and concern as to whether the children will or will not go to college. Many on this board are optimistic and just say that in that case the money can go to the next generation or whatever, but that is a lot easier to say if you are relatively wealthy.