Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

If you have not already, you could soon get a refund on certain college expenses as campuses across the country closed and schools shifted to remote learning because of the coronavirus pandemic.

But if you used withdrawals from a 529 college savings account to cover these costs, you should handle these refunds with care to avoid tax penalties.

Here are some things you should know if you have opened a 529 plan to help save for education costs, used the funds on tuition or other qualified expenses, and expect to get a refund because of the recent pandemic changes.

How do I avoid tax penalties on my refund?
If you do not handle your refund correctly, it could be seen as a withdrawal to cover nonqualified expenses, which would be subject to tax penalties.

There are two ways to deal with a refund to avoid paying extra taxes: You can spend the refund on other qualified expenses or put the money back into any 529 account with the same beneficiary. If you choose the latter, the refund must come directly from a college or university, and the timing of when you make the deposit is crucial. What to keep in mind:

  • Typically, 529 account owners must deposit the refund into the account within 60 days or the refund will be treated as a nonqualified withdrawal, which gets a tax penalty.
  • The money does not need to go to the same 529 plan that you made the original withdrawal from, but the refund must go back into a plan with the same beneficiary.
  • If you wait longer than 60 days to deposit the money back into a 529 account, it will be considered a new contribution, and the tax penalty on the refund will still apply.

This 60-day rule has shifted slightly in response to the coronavirus pandemic. As stated in IRS Notice 2020-23, 529 account owners who got refunds prior to May 15 now have until July 15 to redeposit the funds into a 529 account. The 60-day window still applies to account owners who receive refunds after May 15.

Could I use my refund to cover next year’s expenses?
While the 60-day period does not apply when you choose to use your refund on other qualified expenses, timing is still important if you want to avoid tax penalties. What to keep in mind:

  • You must make your withdrawal in the same tax year that you pay for the qualified expenses.
  • If you file your taxes using a calendar-year period, which is typical, you can use your refund to cover qualified education expenses, like tuition and room and board, for the fall semester because the refund and payment fall in the same tax year.
  • Even if you are technically paying for 2021 costs, the refund will still count as a qualified withdrawal if you make the payment in 2020.

What are some expenses that I could use my refund to cover?
You can use tax-free withdrawals from a 529 account to pay for qualified expenses (see Section 8 of this IRS document) that include tuition, mandatory fees, books, computers and software.

Because many colleges and universities have set up online courses, it may make sense to use the money to pay for Internet access or to purchase a computer.

You could also put the refund toward student loans. As part of the Setting Every Community Up for Retirement Enhancement Act, or SECURE Act, up to $10,000 total from a 529 plan can be used to repay the beneficiary’s student loans. This includes federal and most private loans. Further, an additional $10,000 can go toward each of the beneficiary’s siblings’ student loans.

Of course, there is no one-size-fits-all approach to using 529 funds. But it is important for investors to understand what costs you can cover without any tax penalty.

What are the tax penalties for nonqualified withdrawals?
Transportation, extracurricular activities, health insurance, and other noneducation costs are considered nonqualified expenses. What to keep in mind:

  • Any taxes or extra tax penalties will only apply to the money that your 529 plan’s investments earn because the contributions you make have already been taxed.
  • Withdrawals from 529s must be a combination of contributions you made to the account and the money you earn from the plan’s investments. For example, if your account has $4,000 in contributions and $6,000 in investment earnings, withdrawing $1,000 takes $400 from contributions and $600 from earnings.
  • Withdrawals for nonqualified expenses get a 10% tax penalty on the investment earnings portion. For example, if you use $1,000 on nonqualified expenses and $600 of the withdrawal come from earnings, you will owe an extra $60 in taxes on top of any income taxes that you owe on that $600.
  • You will owe applicable federal income taxes on your investment earnings but not contributions.
  • You may have to repay any state income tax breaks you received on those contributions.

 

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