Received IRS notice that I had to include the earnings from 529 fund as income and I know owe taxes on this. I thought if you applied it to education you did not have to.

[Lisa995]

You need to report it and indicate on the return that it was used for education...they don't know what you used it for otherwise.

[Hal_Al · Accepted solution]

Part of the problem is that there is nowhere on the IRS tax forms to indicate that you had qualified educational expenses. It's only shown on the TurboTax (TT) work sheets that are not sent to the IRS.  So, you may just be a victim of a random IRS inquiry, because they get a copy of the 1099-Q.  We have seen this problem before, here in the answerXchange.

First verify that you qualify for a total exclusion of the 529 plan earnings, shown in box 2 of the 1099-Q. Be aware, you cannot double dip. You cannot count the same tuition money, for the tuition credit,  that gets you an exclusion from the taxability of the earnings (interest) on the 529 plan distribution. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion.

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 

Example:
  $10,000 in educational expenses (including room & board)

   -$3000 paid by tax free scholarship

   -$4000  used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q 

  Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360) 

If you totally qualify, you need to write back to the IRS with your numbers. Include copies of the schools billing statements, showing your payments. You may want to include the TT work sheets ("1099Q Summary" & "Student Info Wk").

If you discover that you do not  fully qualify because you did not adjust for scholarships and/or claiming the tuition credit, you will need to prepare an amended return to verify that the IRS calculations are correct (they usually aren't in this situation). 

See https://ttlc.intuit.com/questions/2662573-where-do-i-enter-1099-q?jump_to=answer_4402991 for a fuller discussion on 529 plans

[Hal_Al]

Here is a  suggested workaround to help avoid a future IRS inquiry:
1. Enter $0 on line 21 of form 1040 with the notation "1099-Q less qualified education expenses".  I do this on my own return.
 In TT enter at:                                                                      
 - Federal Taxes tab                                                                                                     
 - Wages & Income                                                                                                        
-  “I’ll choose what I work on” Button                                                                  
Scroll down to:                                                                                                          
-Less Common Income                                                                                           
 -Misc Income, 1099-A, 1099-C                                                                                 
- On the next screen, choose – Other reportable income - Enter the notation and zero as the amount

[mjlongo]

This is now happening to me.  How did you ultimately respond and settle with the IRS?

Thanks!

[Hal_Al]

@mjlongo 

I actually used that workaround on my own return.  It didn't help. I got a CP2000. I replied to the IRS that it was all used for qualified education expenses. I attached a copy of my billing statement from the school and a copy of TurboTax's 1099-Q work sheet (which was not part of my original filing) and that took care of the problem (2-1/2 months later).

At least two users have reported receiving a CP2000 letter, from the IRS,  on 529 distributions. They replied that their child was in college and the distributions were for qualified expenses, which they listed, but they did not provide receipts.. They  later received a notices saying they were in the clear.