How to Avoid Tax Consequences from College Refunds

One of the unfortunate consequences of the coronavirus pandemic was the cancellation of classes halfway through the spring semester at many colleges and universities. Many of them are now refunding a portion of students’ tuition, fees, and room and board as a result of these cancellations. 

If you have received one of these refunds, you might be wondering about the potential tax consequences of the refunds if the money came out of a Section 529 college savings plan or Coverdell education savings account (ESA). Here’s what you need to know about how to handle refunds of tuition, fees, and room and board that resulted from the coronavirus pandemic.

Recontributing Your Refund

According to law, withdrawals and distributions from 529 plans and Coverdell ESAs must be used to pay for qualified education expenses. If they aren’t, income taxes and a 10% tax penalty will be assessed against the earnings portion of these withdrawals. Since refunds would no longer be deemed to have been used for qualified education expenses, they could be subject to taxes and penalties.

Fortunately, there’s a way for you to avoid this tax exposure. You simply have to recontribute the money back into your account within a certain period of time. Note that the amount of the recontribution cannot exceed the amount of your refund. If it does, the excess amount will be considered to be a new contribution, not a recontribution. Recontributions must be made within 60 days of receiving the refund or by July 15, 2020, whichever comes later.

The entire amount of the recontribution is treated as principal, not a mix of principal and earnings. The refund must be recontributed to the same child’s college savings account. Also, the recontribution will not be counted against your aggregate contribution limit. 

Other Solutions

There are a couple of other ways you can avoid taxes and penalties on refunds of college tuition, fees, and room and board. One of these is to look for other qualified college education expenses that you could allocate the refund to. For example, you could possibly use the refund to purchase a computer, software or other school supplies for your student to use in summer classes or when returning to school in the fall.

Another option is to apply the refund to qualified education expenses for the fall semester. In this situation, there will be no tracking or tracing of account distributions. For example, if you receive a $1,000 refund for the spring semester and your child will be returning to the same school in the fall, you could apply this refund to fall’s tuition payment. This would save you $1,000 when it comes time to pay fall tuition.

Instead of sending cash, some colleges and universities are sending students and their families vouchers or credits toward future tuition since they cost colleges much less than issuing cash refunds. So what should you do if you receive one of these “coupon” refunds? In short, nothing. Since a coupon isn’t cash, it can’t be recontributed to a college savings plan and does not create a taxable event.

Steps to Follow

It’s important to follow the right steps to ensure that your recontribution is properly categorized. Specifically, you should:

1. Document the refund by printing out and storing records of the date you received it and the refund amount. You may need this if you ever have to prove that the recontributed amount should not be treated as a taxable distribution.
2. Send detailed instructions to your 529 plan or Coverdell ESA provider stating that the amount is for a recontribution, the amount of your recontribution, your student’s name and account number, and the date and amount of the qualified withdrawal that the recontribution is intended to cover.
3. Send a check to the plan provider instead of making the recontribution payment electronically and write “Recontribution of 2020 college refund amount” in the subject line. This way, you’ll have a paper trail to document the recontribution process.

Please feel free to contact us if you have any more questions about recontributions of refunds from your child’s college or university.