A College Refund Could Mean a Tax Penalty if You Paid with a 529 Plan

January 15, 2021 | Stacy Miller, CFP®, Bright Investments, LLC

This week my son got a refund for overpaying his spring semester college tuition. His first thought? YAY! Then he talked to me . . .

If you receive a college refund and any part of your original payment came from a 529 Plan, it is important to understand that that refund may be taxed, and a 10% tax penalty may also be added.

To clarify, a 529 College Savings Plan is a Qualified Tuition Program designed to help you pay for college. The benefit of investing in a 529 Savings Plan is that earnings are tax-deferred, and those earnings will be tax-free if used for Qualified Educational Expenses. Qualified Education Expenses currently include the following: tuition, room & board, books, fees, computers, and supplies for 2 or 4-year public or private colleges, trade schools, vocational schools, graduate schools, professional schools, K-12 schools (up to $10,000/year), apprenticeships, and student loan principal and interest payments ($10,000 lifetime limit).

So why could a refund be taxed and penalized? If you originally paid for Qualified Education Expenses, but then got a refund which can be used for anything (I am sure my son was thinking about video games), the IRS could declare the refund as Non-Qualified Education Expenses and tax and penalize that amount.

What can you do to avoid the taxes and penalty? You can put those funds back into your 529 Plan within 60-days of the refund. That is what my son is doing, and as a bonus, those funds may grow before he needs to pay for next semester.

As always, please reach out to a trusted accountant and/or financial advisor to discuss specifics on your own situation.