Oops, I withdrew too much 529 money!

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Financial Professional Content

There are times when a beneficiary will receive tuition refunds or credits after 529 funds have been used to pay the expenses. Will there be tax and penalty to pay? The answer is that it depends on the situation. Here is how the rules work and how your clients can eliminate or minimize negative consequences.

1. Do not put the over-withdrawal back into the 529 account

Most of the time a distribution from a 529 plan cannot be “undone” by putting the money back into the plan. The plan administrator will simply treat the replacement money as a new contribution, and the Form 1099-Q issued at the end of the year will still show the original distribution amount. However, if the beneficiary's school returns money previously taken as a qualified withdrawal to you, such as a tuition reimbursement, you can recontribute those funds back into the account anytime within 60 days of the refund without any tax penalties.

2. Look for other qualifying expenses

Sometimes, an excessive withdrawal doesn't end up being excessive. Sometimes, you just need to take a step back. Combine ALL qualified higher education expenses incurred during the calendar year—including tuition, fees, room & board, books, supplies, and equipment—and THEN subtract any refunds or credits, along with any expenses used to generate the American Opportunity Tax Credit.

As long as the resulting amount is greater than total 529 withdrawals for that year, those withdrawals remain tax-free.

3. Rollover to another 529 plan

Your client has 60 days from the date of a 529 withdrawal to make a full or partial rollover of those funds to another 529 plan without tax or penalty. As soon as it becomes apparent that a refund or credit has caused an over-withdrawal, the client should be checking to see if the 60-day window is still open.

A 529 beneficiary is permitted only one tax-free rollover in a 12-month period. If the situation shows that a corrective rollover would run afoul of the 12-month rule, the rollover must go into a 529 account for another qualifying family member. That can usually be accomplished without a problem, and the funds can be even brought back into the current beneficiary’s 529 account at any time after.

RELATED: Avoid these 529 withdrawal traps

4. Make it a habit to take 529 withdrawals late in the year.

By waiting until December before taking 529 withdrawals, your client will have a better fix on the total amount of qualified higher education expenses incurred during the year and how much can be withdrawn tax-free. Any credits or refunds will have already been processed on the student’s account and can be appropriately handled in requesting the distribution.

If the 529 account is appreciating in value, the delay will also generate greater tax-free returns.

5. Pay next year’s school bills before the end of this year.

In spite of their best planning efforts, your clients may determine that they have over-withdrawn their 529 account. They can increase this year’s qualified higher education expenses by paying some of next semester’s bill before December 31.

6. Account for any scholarships or grants received.

In the “worst case” the client does not do anything to correct the over-withdrawal, or discovers it only after year-end when it is too late. The result is that some portion of the withdrawal will be non-qualified, and the earnings portion of the non-qualified will be subject to tax and 10% penalty.

But wait! The 10% penalty is waived when withdrawals can be attributed to tax-free scholarships or grants received by the student. Be sure the client looks into this. Identify scholarships and grants received not only for the current year, but also any received in prior years that have not previously been applied to the penalty waiver.

If the 10% penalty can be waived, the worst case may not be bad at all. The earnings portion of a non-qualified distribution will be taxed to the individual that receives the Form 1099-Q. Let’s hope your client requested distributions be made to the student (or to the school), and not to the account owner—and that the student is in a low tax bracket.

RELATED: 8 common 529 plan mistakes to avoid

Originally posted 2014-01-30