Coverdell/ 529 withdrawals for a non-US Institute

[scotttiger]

Hi,

My child (age 23) is considering attending a top foreign fashion institute for 4 years, but it is not listed on the Department of Education’s list of participating schools for financial aid. I've saved into a Coverdell and a 529 for years, and now I read that to make a deduction from a Coverdell to pay for tuition, the school must be on the list.

Is this true?

If so, what are our options to use the Coverdell money to pay for expenses there? Does the restriction only apply to tuition, or can we at least pay for the expenses related to the school (materials, rent, food, etc)? The school's tuition is low enough that we would not need any financial aid, and we actually have enough saved in the Coverdell to pay all four years of tuition and expenses.

It's always been the plan to avoid financial aid and rely solely on the Coverdell, and now it seems like if we tap it -- even to pay legit higher educational expenses -- we will either have penalties or taxes, or both. We won't have a 1098-T, but I heard that is not needed even for a US school (is this true also?).

Does it help if we transfer the account to a 529 plan? (i.e., are the rules the same for those accounts?)

Any help to navigate this issue or to help us understand penalties/taxes, etc is greatly appreciated.

It seems a shame to have saved so diligently and not be able to use the money as intended.

[MaryK4]

Unfortunately, if it is not a qualified educational institution, you will not be able to use the 529/Coverdell plan tax free.  

In general, the designated beneficiary of a Coverdell ESA can receive tax-free distributions to pay qualified education expenses. The distributions are tax-free to the extent the amount of the distributions doesn't exceed the beneficiary's qualified education expenses. If a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable to the beneficiary. 

[scotttiger]

Thank you, MaryK4.

So, now it seems I still must tap those funds to pay for the education or move them to another child.

If the former, what is the tax basis? I already paid tax on the money going in. How do we figure it out how much to pay on the rest?

Is there a way the child can pay the tax based on his/her tax situation or rate? Can I transfer the account to the child? This child has actually not been a dependent on my tax form for the past few years, but I had planned to have this child as a dependent this year. If she is not a dependent, will that help to avoid taxes at my rate?

If I were to hold the money in the account until the child reaches 30, then is it taxed or is it rolled into a retirement account?

This is all so discouraging. I have this great big chunk of money that I just don't know the best way forward regarding it. Who knew when we planned for education that the child would choose an institution outside of the country to pursue a degree?

[AmyC · Accepted solution]

1. Yes. If you choose to use the funds on education expenses that are not qualified, you will pay tax on the earnings. Some foreign institutes do qualify. Otherwise, you can move funds to another beneficiary.

2. You have already paid tax on the dollars you put into the program at the federal level and maybe the state level. Those already taxed dollars are your basis. You won't pay tax on them again. The earnings will be taxable.

3. The child can pay if they are the owner. See the rules here.

4. Talk to your plan administrator, you may be able to transfer to your student depending on a few factors.

5.Her being a dependent does not affect which of you claims the excess income. Her dependency would only matter if you were getting the education credit.

6. There is a $35,000 cap for 2023 of the amount you can roll into a ROTH IRA for your child. See other time and age limits here.

[scotttiger]

Hi Amy,

I am still a little confused. I have accepted the fact that, since the distributions are going to school expenses for a school not on the Dept of Education list, they will be taxable minus the basis.

I did look at the rules referenced in point 3, but I didn't see how to make her the owner of the account. Honestly, I want to retain ownership; is there a way to make a distribution to the benefit of my daughter, and have her be the one paying the tax? I ask, since that seems to be a possible option from the following sentence: "However, the account owner (such as a parent) will receive the 1099-Q instead if the distributions from a 529 plan aren’t made directly to the beneficiary..." It seems like one can make distributions direct to the beneficiary.

Does it make any difference pulling money from a 529 or a Coverdell? I can move money freely between those accounts set up for her benefit.

Also, will there be an additional 10% penalty over the taxes due, even though she is actually going to a school? It is not clear - especially since she is really in a school, just not in the US or on the approved list of foreign schools. It seems really harsh to have saved all these years and then pay a penalty under these circumstances; I can accept paying tax - like I would have all along - but an extra 10% penalty is really hard to swallow

[scotttiger]

Hi MaryK,

I was wondering if there is also an additional 10% penalty when we pull out the money to pay for her schooling expenses since her school is not on the approved list.

Also, can the distribution be made directly to her - thus making her the one to pay tax (at her much lower tax rate)?

Please let me know when you can.

Thanks,

Scott

[Carl]

Excuse me for jumping in here. But just because you don't see the school on the "official list" doesn't always mean it's not a qualified school. That list sometimes goes for a few years without being updated. So check with the school directly to see if they are a qualified institution. If they are, ask them to mail, fax or e-mail you the paperwork they would have received from the U.S. Dept. Of Ed. that proves it.

Basically, an eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.

So if the school is eligible for student aid administered by the DOE,  they should be able to provide paperwork showing that. (One of a few possible examples would be FAFSA)

[Hal_Al]

Q. I was wondering if there is also an additional 10% penalty when we pull out the money to pay for her schooling expenses since her school is not on the approved list.

A. Yes, because it is a non-qualified distribution. 

Q. Also, can the distribution be made directly to her - thus making her the one to pay tax (at her much lower tax rate)?

A. Yes, as long as she is not covered by the the "kiddie tax". Generally, the kiddie tax applies to all children age 18 or younger, as well as to full-time students who are between 19 to 23 years old and whose earned income is ≤ 50% of his/her support, regardless of whether they are your dependent.  Even when the kiddie tax applies, a small portion of the income is taxed at the child's rate.

As others, have suggested, you can consider a beneficiary change. 

https://www.savingforcollege.com/article/how-to-change-the-beneficiary-on-your-529-plan#:~:text=529%....

An ownership change may also be allowed. Check with your plan administrator.

[scotttiger]

Thank you so much, Carl, for "jumping in."

I have asked my daughter to do just what you advised: to inquire directly to the institution.

[scotttiger]

Thank you, Hal, for the insights. She is indeed soon to be over 23, and is earning her own keep now, for the most part. To have the distribution taxed at her rate - even with a penalty, which is really irksome if the institution is not "on the list" - is at least some comfort.