I recently received the following question:
Help! My son just dropped out of college part of the way through the Fall semester. I have already paid or reimbursed myself for his off-campus housing, tuition, books, and a one month of food expenses from the 529 plan. What happens to all those distribution? Are they still qualified education expenses or does someone owe taxes and penalties on the distributions?
The default assumption for 529 distributions is that the account owner will report and owe tax on any distributions. As the US Code 529(c)(3) states:
(A) In general
Any distribution under a qualified tuition program shall be includible in the gross income of the distributee in the manner as provided under section 72 to the extent not excluded from gross income under any other provision of this chapter.
It is only if you satisfy an exception that the distribution is free of taxation. Luckily for 529 owners, there are several exceptions.
The exceptions that follow in the code are:
- (B) Distributions for qualified higher education expenses
- (C) Change in beneficiaries or programs
- (D) Special rule for contributions of refunded amounts
For each distribution, you will need to see if it meets one of these exceptions. If an expense does not meet an exception, then it will be included in gross taxable income.
You have reimbursed yourself for off-campus housing, tuition, books, and a one month of food expenses so far. Off-campus housing and food, also called room and board, are the most complicated of these, so let’s start there.
Room and Board (e)(3)(B)
A “qualified higher education expense” is defined in US Code 529(e)(3) and its two further subsections. Subsection A contains the requirements for most qualified education expenses. Subsection B contains the requirements for room and board expenses. Subsection B states (blue emphasis added):
(3) Qualified higher education expenses
(B) Room and board included for students who are at least half-time
(i) In general
In the case of an individual who is an eligible student (as defined in section 25A(b)(3)) for any academic period, such term shall also include reasonable costs for such period (as determined under the qualified tuition program) incurred by the designated beneficiary for room and board while attending such institution. For purposes of subsection (b)(6), a designated beneficiary shall be treated as meeting the requirements of this clause.
The amount treated as qualified higher education expenses by reason of clause (i) shall not exceed—
(I) the allowance (applicable to the student) for room and board included in the cost of attendance (as defined in section 472 of the Higher Education Act of 1965 (20 U.S.C. 1087ll), as in effect on the date of the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001) as determined by the eligible educational institution for such period, or
(II) if greater, the actual invoice amount the student residing in housing owned or operated by the eligible educational institution is charged by such institution for room and board costs for such period.
All room and board expenses, both on and off campus, require the designated beneficiary be an eligible student to be qualified higher education expenses. To see if a student who drops out counts as an eligible student, we need to review that definition.
Eligible student is defined in 25A(b)(3). That section reads:
(3) Eligible student
For purposes of this subsection, the term “eligible student” means, with respect to any academic period, a student who—
(A) meets the requirements of section 484(a)(1) of the Higher Education Act of 1965 (20 U.S.C. 1091(a)(1)), as in effect on the date of the enactment of this section, and
(B) is carrying at least ½ the normal full-time work load for the course of study the student is pursuing.
Requirement B, that a student needs to be carrying at least half of the normal full-time work load for the course of study, is the one that a drop out may not satisfy, but the language is imprecise.
Most institutions have clearly defined minimum credit hours for full-time enrollment. Here is an example of that page for UVA, which currently puts full-time enrollment at more than 12 credit hours. Even so though, it is still unclear what it means to “carry” the work load.
What counts towards your work load? Is it the credit hours of the courses you enrolled in at the start of the semester, regardless of if you finish? Is it only the credit hours you completed? Do “incomplete” or failed grades count? How do you consider the fact that a drop-out is only a student for part of the year? Do you get to pro-rate the amount of hours you satisfy, so if you last 52% of a full-time semester you’d count as at least half of full-time?
There are no easy answers. This is what makes room and board a tricky one for eligible students.
I merely present the law and the possibilities here for your or your tax preparer’s interpretation. You can evaluate what you are willing to defend in tax court, if it comes to that, and whether it is worth the risk.
There is only one case that feels clear to me:
If you were reimbursed literally all of the tuition you paid because the student dropped all classes before the Add/Drop deadline, then from the perspective of almost all records it is as though the student was never enrolled at the institution. Surely then, they would not qualify as an eligible student, even though, alas, you may have already incurred and reimbursed for housing expenses thinking that they would be.
If this is your situation, jump down to the section on how to correct mistakes.
Tuition, Books, Supplies, and Equipment (e)(3)(A)
In the definition of a “qualified higher education expense,” section A of US Code 529(e)(3) is where the average qualified expense is defined. That section states (blue emphasis added):
(3) Qualified higher education expenses
(A) In general
The term “qualified higher education expenses” means—
(i) tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution,
(ii) expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance, and
(iii) expenses for the purchase of computer or peripheral equipment (as defined in section 168(i)(2)(B)), computer software (as defined in section 197(e)(3)(B)), or Internet access and related services, if such equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution.
Clause (iii) shall not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature. The amount of cash distributions from all qualified tuition programs described in subsection (b)(1)(A)(ii) with respect to a beneficiary during any taxable year shall, in the aggregate, include not more than $10,000 in expenses described in subsection (c)(7) incurred during the taxable year.
Expenses such as tuition, books, and supplies are qualified higher education expenses if they are “required for the enrollment or attendance of a designated beneficiary at an eligible educational institution.”
Notably and unlike room and board expenses, the designated beneficiary is not required to be an “eligible student” nor are they burdened by a work load requirement.
Imagine a student enrolled in only one class at an eligible higher education institution. Based on these rules, even that student would be able to reimburse for the required tuition, fees, books, supplies, and equipment required for that class. From this example, you can both see how permissive the rule is and why it is so permissive.
If a student who dropped out incurred expenses that were required for their enrollment or attendance at an eligible education institution, they can reimburse themselves for those actual expenses.
If you can reimburse for the partial tuition and fees, then you should be able to reimburse for supplies as well, because all of these expenses are evaluated the same way.
Most of the time when you drop out part of the way through an academic year, you will be refunded a portion of your tuition from the institution. Because you were refunded part of the tuition, that means that your actual expenses have now been decreased by the amount they refunded you.
Thus, your 529 distributions may exceed actual expenses by the refunded amount. Distributions in excess of your actual expenses are included in gross income according to the default case.
However luckily, one of the exceptions for distributions is subsection (D). This section creates a special rule for contributions of refunded amounts. That exception states:
(D) Special rule for contributions of refunded amounts
In the case of a beneficiary who receives a refund of any qualified higher education expenses from an eligible educational institution, subparagraph (A) shall not apply to that portion of any distribution for the taxable year which is recontributed to a qualified tuition program of which such individual is a beneficiary, but only to the extent such recontribution is made not later than 60 days after the date of such refund and does not exceed the refunded amount.
This means that you have 60 days from receipt of the refund to contribute the refunded amount to the student’s 529 to avoid the taxes and penalties of a non-qualified withdrawal.
Notably, there is no provision that allows you to re-contribute any other type of excess distribution other than refunds from the eligible educational institution. This means that even if your housing refunds you for the months you will not be there or you are able to return your textbooks to the bookstore, no re-contribution of those funds to the 529 plan will protect them from taxation.
However, there is one loophole that will allow you to protect these funds from taxation but you must act quickly.
Subsection C permits a last exception to the default case. That section reads in part:
(C) Change in beneficiaries or programs
Subparagraph (A) shall not apply to that portion of any distribution which, within 60 days of such distribution, is transferred—
(I) to another qualified tuition program for the benefit of the designated beneficiary,
(II) to the credit of another designated beneficiary under a qualified tuition program who is a member of the family of the designated beneficiary with respect to which the distribution was made, or
(III) before January 1, 2026, to an ABLE account (as defined in section 529A(e)(6)) of the designated beneficiary or a member of the family of the designated beneficiary.
Subclause (III) shall not apply to so much of a distribution which, when added to all other contributions made to the ABLE account for the taxable year, exceeds the limitation under section 529A(b)(2)(B)(i).
You are permitted to withdraw funds from the 529 plan of one beneficiary and contribute them to the 529 plan of another family member assuming you complete the transfer within 60 days.
If you are still within 60 days of your reimbursement distribution from the drop-out’s 529 plan, you can contribute those funds to a 529 plan for the benefit of another family member. You can read more about this in “How to Transfer 529 Funds From One Family Member To Another.”
You may have to act quickly though, as I imagine at least several weeks have passed since those expenses were incurred. This technique would let you contribute those funds to a sibling’s 529 plan in order to avoid taxation this year.
Note that you can transfer assets between the accounts of siblings or first cousins or transfer up to parents or grandparents without any worry. However, if you transfer assets down the family tree, from parents to children for example, you are limited by the annual exclusion for gift tax and Generation-Skipping Transfer tax law.
Hopefully this simple guide helps you get started in the right direction for correcting these surprise excess distributions.
Photo by Jaeyoung Geoffrey Kang on Unsplash