One of the many unfortunate but necessary consequences of the COVID-19 outbreak was the physical closure of many colleges and universities and private secondary schools. Some replaced classroom instruction with online classes, while other institutions shut their doors entirely. Meanwhile, thousands of students were evicted from campus housing.
As a result, many students (or their parents) have received or will receive partial refunds of the money they paid for this semester’s tuition and room and board.
This presents a potential tax risk for parents and students who originally paid a portion of these costs using withdrawals their 529 College Savings Plan accounts. Since the refunded amounts are no longer being used for qualified educational expenses, the IRS could recharacterize them as taxable distributions. In this case, you’d have to pay a 10% penalty and income taxes on a certain amount of the earnings portion of the distribution, but you wouldn’t have to pay taxes on the principal.
To avoid this risk, 529 plan account owners should consider recontributing refunded amounts into their accounts. The catch: This must be done within 60 days from the date the refund was issued.
If you have a financial adviser, they should be able to help you with this process. If you (or the actual 529 plan account owner) need to do this on your own, you’ll need to complete a series of steps to make sure it's done correctly.
First and foremost: Contact the 529 plan provider
Different states and 529 plan providers may have specific requirements for fulfilling and documenting recontributions. They should be able to provide specific instructions. However, most providers are likely to require some variation of the following steps.
Step 1: Document the refund
Print out and store records of the date and amount of the refund from the institution. You’ll need these in case the IRS or the 529 plan provider ever requires proof that the recontributed amount shouldn’t be treated as a taxable withdrawal.
Remember that you should only recontribute the portion of the refund paid for by your 529 plan withdrawals. For example, if you originally withdrew $10,000 from your account to help pay for the spring semester’s college costs and the college refunded you $4,000, you should only recontribute $4,000.
Step 2: Write a detailed letter of instruction
Along with your recontribution, you should include a detailed letter of instruction that states:
- The amount that you want to recontribute to your 529 plan account.
- That you want this payment to be characterized as a recontribution of a previous qualified withdrawal from the account, rather than as a new contribution.
- That you’re making this recontribution within 60 days of receiving a refund from the educational institution. Include the name of the institution and the date the refund was issued.
- The account number and the name of the student beneficiary.
- The date and amount of the specific qualified withdrawal from the account that this recontribution is designed to fully or partially cover.
You may wish to include a copy of the printed refund statement from the institution to ensure that this information remains “on the record.”
Step 3: Send a check
Following the process recommended by the 529 plan provider, you (or whoever is the actual account owner) should send a check for the amount you want to be recontributed into the account along with the letter of instruction. Why a check rather than an electronic payment? Because you’ll want to keep a complete paper trail to document this process. You may even want to write “529 plan recontribution of 2020 school refund amount” in the memo line.
Before you send the check and letter of instruction, make a copy of both and any other supporting documentations for your own records. You may also want to send the letter and check via certified or registered mail to verify that it meets the 60-day window.
The importance of doing it right
It’s extremely important for you to follow and document this process correctly. If you don’t, or you miss the 60-day window, the IRS may treat the money you send as a normal 529 plan contribution, and characterize the original withdrawal as a non-qualified, taxable withdrawal.
If you have any questions about this process, consult with your tax adviser. If you have a financial adviser, you may want to set up a meeting with both of them to make sure you’re all fully in sync about what needs to be done.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax adviser or lawyer.
Chris Gullotti, CFP® is a financial adviser and Partner at Canby Financial Advisors (opens in new tab) in Framingham, MA. He has an MS in Financial Planning from Bentley College. He brings a big picture view to each client's situation and works cooperatively with his clients' other financial professionals, including family attorneys, tax professionals and insurance advisers.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.
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