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No parent expects their child’s circumstances to change mid-semester. However, health issues, personal challenges, family matters, or academic struggles can mean moving off campus, dropping down to part time, taking a leave of absence, or moving back home. During such an upheaval, getting a refund for tuition and fees or room and board can be a relief.
It’s important to manage that refund carefully to maximize your available funds for future college expenses. That’s especially true if you’re using a 529 plan, because you may need to return the money to your plan to avoid tax penalties. The earnings portion of 529 plan withdrawals must be used for qualified higher education expenses to maintain their tax-free status and avoid a 10 percent tax penalty.
The following conditions apply when you want to recontribute a college refund to a 529 plan:
- Recontribute the unused funds to a 529 plan within 60 days.
- Include all the relevant details with your recontribution.
- Keep detailed records for tax preparation and in case of an IRS audit.
Here’s how to meet each of these conditions, and how to decide whether it’s worth doing a recontribution at all.
Considerations for recontributing a college refund to a 529 plan
As a hypothetical example, let's say you took a 529 plan distribution of $20,000 to pay for college, and now the college has refunded $10,000 of that money. Here are five ways you might choose to handle the refund.
- Do a recontribution by putting the refund back into the same 529 plan within 60 days.
- Do a recontribution by putting the refund into a different 529 plan for the same beneficiary within 60 days.
- Use it within the same tax year for other qualified educational expenses for the same beneficiary.
- Use it to pay down student loans for the beneficiary or the beneficiary’s siblings.
- Put it in the bank now and potentially pay federal and state taxes and penalties at tax time.
The first two options will require some administrative steps, which we’ll detail below. The third option entails uncertainty, because you may not know when your child will return to college or if they’ll return to the same college with the same expenses. (Related: Alternatives for the non-college bound)
“It is much safer to recontribute the money to a 529 plan for the beneficiary,” said Mark Kantrowitz, publisher and vice president of research for Savingforcollege.com. You don’t want to lock yourself into finding additional qualified expenses to justify the refund as a qualified distribution. “If you fall short, that portion of the refund turns into a nonqualified distribution,” he said.
Plus, if your child receives a college refund during the fall semester, the likelihood of incurring more qualified educational expenses that year is low. That said, if you do want to use the third option, you could put the money toward online education at a qualified institution (one that is accredited and participates in the federal student aid program); toward a computer and other hardware or software for school; or toward internet access fees for school. You cannot put the money toward the travel expenses of your child’s early return from college. (Related: 10 mistakes to avoid with 529 savings plans)
The fourth option could mean paying less interest on student loans and could help your child graduate with less debt. However, depending on how much progress they’ve made toward their degree, you might end up reborrowing that money later.
The fifth option is perhaps the least appealing and the one most families will want to avoid.
The tax impact of unqualified 529 plan withdrawals
Each 529 account performs differently depending on many factors, such as how long the money has been invested and what investment options the account owner has chosen. As such, there’s no way to show what the typical tax impact would be for an individual, said Tim Gorrell, executive director of Ohio’s 529 plan, CollegeAdvantage. However, the account owner can see the principal and earnings associated with their withdrawals by calling the plan administrator or accessing their account online.
Then, there’s the question of who would owe the tax. Gorrell said that withdrawals can be sent to the account owner, the beneficiary (student), or the school.
“The tax burden would fall on the account owner if the original withdrawal was sent directly to that individual,” he said. “If the withdrawal was sent to the beneficiary or the school, the tax burden would fall to the beneficiary.”
The tax could be higher if it falls on the account owner, who is likely the student’s parent or another adult in a higher tax bracket than the student. Consider asking a tax professional what makes the most sense in your situation.
That being said, here’s a simple example from Kantrowitz to show what the federal tax impact might be on a nonqualified distribution.
Let’s say the student gets a $10,000 tuition refund, and all $10,000 of that money originally came from a 529 plan. Next, assume that one-third of this distribution, or $3,333, is considered earnings, and that the tax liability falls on the beneficiary, who is in the 12 percent tax bracket.
The income tax owed on the distribution would be 12 percent of $3,333, or $400. The beneficiary would also owe a tax penalty of 10 percent on the $3,333 in earnings, for an additional $333 and a total tax bill of $733. Any possible recapture of state tax breaks would increase this total. (Learn more: Pros and cons of using non-college accounts for college savings)
Recontribute unused funds to a 529 plan within 60 days
The 60-day clock starts ticking on the date the college issues the refund (the check date or direct deposit date). The money does not have to go back to the same 529 plan it was distributed from, but it does have to go back to a 529 plan for the same beneficiary for it to count as a recontribution.
Contact the plan to find out what its process is for recontributions. For example, Ohio’s CollegeAdvantage 529 plan requires that recontributions be made by check and accompanied by a signed letter of instruction.
Some plans might allow you to sign over the refund check from the school, while others might require you to write your own check for the redeposit. Some may have their own form you can fill out instead of writing a letter of instruction. Some might allow electronic transfers.
Regardless of the method, the 529 plan will need certain details from you to process the recontribution.
Include all the relevant details with your recontribution
Any letter of instruction or recontribution form should include these details:
- The date
- A statement that you are making a recontribution due to a school refund (not a new contribution)
- The date of the school refund
- A statement that your recontribution is being made within 60 days of the refund
- The name of the school
- The amount of the recontribution
- The date of the original 529 withdrawal
- The account number of the original 529 withdrawal
- The account beneficiary’s name
- A copy of the refund statement from the school
Sign the letter or form, and send it using a method that lets you confirm the delivery date so you can prove you were within the 60-day window if the IRS ever asks.
Keep detailed records for tax preparation and in case of an IRS audit
Your taxes may be more complicated this year because of the refund and recontribution. You’ll receive form 1099-Q from the 529 plan at tax time, but it will show the amount of the original withdrawal and will not reflect the recontribution.
“This is one of the many reasons it is very critical for the account owner to keep detailed records,” Gorrell said. (Related: Preparing for a tax audit)
Here’s what 529 experts say your records should include:
- The reason for the college refund
- A copy of the refund statement from school
- A copy of the refund check from school
- A copy of your letter of instruction or recontribution form
- A copy of the recontribution check
- Copies of your 529 plan statements showing account balances before and after the recontribution
- Planning the path forward when circumstances change
Leaving college mid-semester can feel like a huge blow for the whole family, but minimizing the financial impact is one way to soften that blow. With help from your 529 plan, tax advisor, and financial professional, you’ll be able to make the best of the situation and ensure that your family doesn’t waste any higher education dollars on unnecessary taxes.
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