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The COVID-19 529 Plan Tax Surprise... And How to Avoid It Thumbnail

The COVID-19 529 Plan Tax Surprise... And How to Avoid It

The Scenario:  A Refund of College Fees May Trigger Taxes On A 529 Plan Distribution

The COVID-19 outbreak has forced most colleges and universities to physically close, resulting in millions of students receiving partial refunds for tuition and associated fees.  However, this could also create a tax dilemma for those that used 529 plan distributions to pay for this year’s schooling.

Remember, distributions from 529 College Savings Plan accounts must be spent on ‘qualified educational expenses’ in order to receive favorable tax treatment.  With these amounts now being refunded, the IRS could re-characterize them as taxable distributions. In this case, you’d potentially have to pay a 10% penalty and income taxes on a certain amount of the earnings portion of the distribution. 

The Solution:  Re-contribute The Funds To The 529 Plan Within 60 Days

Thankfully, with the passage of the PATH Act in 2015, a mechanism is in place to help you avoid this potential tax trap.  According to the PATH Act, if the beneficiary or account owner of a 529 plan receives a refund of qualified higher education expenses from the college or university that were paid for with a 529 plan distribution, the refund can be recontributed to the 529 plan within 60 days of the date of the refund without having to pay any taxes and penalties on the distribution.   Here’s how:

Each 529 provider will have their own steps so it is important to contact them directly.   For example, those with an Edvest 529 plan in the state of Wisconsin simply need to write the account number that it should be re-contributed to on the front and then endorse the refund check over to Edvest and send it in.  However, not all plans will operate this way so be sure to contact yours independently. 

Keep a paper trail of everything involved.  Remember, you have 60 days from the time the refund was issued to re-contribute it to the account.  And, you can only re-contribute the portion refunded that was paid for with 529 withdrawals.  In other words, if you receive a $3,000 refund but had only taken $1,000 out of the 529 plan for expenses, you should only re-contribute $1,000.   

I would recommend documenting the process in the following manner:

  1. Keep a copy of the check(s) received and all paperwork that came with it.  
  2. If you already deposited the check into a bank account, keep a copy of the statement showing the deposit along with a copy of the new check you have sent to the 529 plan.
  3. Keep a copy of the 529 statement showing the date and the contribution amount going back in.

If you have any questions about this process, consult with your tax adviser and financial adviser.  You may even want to bring them together for a quick email conversation or phone call to make sure they are on the same page.  Abiding by the 60-day rule, following the proper steps, and documenting everything should help save you from a surprise at tax time that many students and parents hadn’t thought of.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your financial advisor, attorney, or tax advisor.  For additional information and disclosures, please visit our website at www.mbewealth.com.