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By Andrew Keshner

'If we withdraw from the 529 and pay tuition and room and board at this school, will this be considered a qualified withdrawal?'

Dear Tax Guy,

My daughter is considering a Canadian school for her Bachelor's degree. The school is on the U.S. Department of Education's website as a "deferment only" school, which means a student cannot get new federal loans while at this school. But if she has existing loans, they can be deferred while she goes to this school.

We have 529 plans for my daughter. If we withdraw from the 529 and pay tuition and room and board at this school, will this be considered a qualified withdrawal? Or will we have to pay taxes on the withdrawal and a 10% penalty on the earnings?

Flummoxed on college financing

Dear Flummoxed,

Your question jumped out to me at a time when higher education costs are in the news.

The Supreme Court recently heard arguments on the Biden administration's bid to wipe away more than $400 billion in student loans.

Your question is about 529 accounts. But these tax-advantaged 529 savings vehicles and student loans are different parts of the same attempt to pay for a degree. These accounts help families build more savings for college so students can incur less debt.

Yet if you and your daughter stick with this particular college, there are potential financial pitfalls -- even with your 529 money.

As you note, a non-qualified distribution results in income taxes on the earnings portion of the withdrawal, and a 10% tax penalty on the earnings. Certain states may recoup their own tax breaks given for past contributions.

"For a distribution from a 529 plan to be considered qualified, the college must be eligible for Title IV federal student aid," said Mark Kantrowitz, an expert on 529 accounts, paying for higher education costs and the author of books including "How to Appeal for More College Financial Aid."

There's around 400 schools beyond U.S. borders that qualify for Title IV federal student aid and 67 are based in Canada, Kantrowitz noted. Here's an Education Department web portal to see which domestic and international schools are eligible, he said.

To your point, however, "since the college is identified as a deferment-only school, distributions from a 529 plan to pay for the college will be considered non-qualified distributions," Kantrowitz said. The non-qualified distributions would also apply to expenses apart from tuition that could otherwise be eligible, he added.

Money from 529 accounts can pay for up to $10,000 in student loans per borrower. But, Kantrowitz wrote, "the student must have been enrolled in a college or university that is eligible for Title IV federal student aid."

There are exceptions for study-abroad programs where the student's home institution is eligible, he said. But that doesn't sound like your plan here.

What's more, if your daughter is pursuing a career in America that needs certain professional licenses, a degree from a non-accredited school abroad could present problems, Kantrowitz noted.

529 plans explained

I hope my reply isn't gumming up the plans.

For those who are not familiar with 529 plans: They are funded with after-tax money and families can tap them free of federal income tax so long as it's for a qualified distribution.

Eligible expenses include tuition, room and board as well as the books and supplies a student needs to participate in class. These accounts held more than $411 billion combined through December, with an average account balance of $25,630.

Another warning: even the using 529 money to pay for airplane tickets to Canada or gas money wouldn't count as a qualified expense, Kantrowitz said.

But it may be folly to focus on just one school. Broadening your search could find a school that's good for your daughter -- and good for the tax-efficient use of your 529 funds.

"What I tell students and parent is don't have a dream school. Have three dream schools," Kantrowitz said.

Starting next year, unused 529 money can get rolled into a Roth IRA for a beneficiary. This is thanks to the year-end passage of SECURE 2.0, wide-ranging legislation focused on retirement savings. Roth IRAs are funded with after-tax money, so they are withdrawn tax-free later on. Some of the pre-existing options for unused money include switching the beneficiary.

"The purpose of the relief is for folks who want to save early for higher education, but aren't sure how much to save," said Kelley Long, financial coach and founder of Find your Financial Bliss. She added, "It just removes one the common arguments against 529s, which is 'hey, you're punished if you put too much in.'"

The beneficiary's 529 account needs to be at least 15 years old and the amount of money destined for the rollover needed to be in the account for at least five years. That includes earnings and contributions, according to an explanation on the new rules from John Hancock Investment Management

There's an overall maximum of $35,000 that can be rolled into the Roth IRA from a 529. That also mixes with other rules, including annual IRA contribution limits and the beneficiary's own earned income requirements.

Bottom line: a college degree can help your daughter get ahead in her life. If you can't use the 529 money for that purpose, the money could help her get ahead on her nest egg.

-Andrew Keshner

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March 20, 2023 23:02 ET (03:02 GMT)

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