1099-Q --Software Incorrectly listing Qualifiable Distribution as Taxable

[TaxGuy_Wannabe]

This is my first time taking advantage of a qualified distributions for my child's college education from the 529 plan.   I received a 1099-Q from Scholarshare for distributions made directly to the University.  These distributions should be exempt from taxes; however, after entering the 1099-Q in the "Deductions & Credits" section, I get the following comment after completing the section:  "Looks like your 1099-Q is taxable"  …"Based on the education expenses you've entered, the student beneficiary must report $XXXXX of taxable income from this distribution"

What is also strange is that the on the summary section under "Education" after completing the section, I can clearly see that Turbo Tax has properly inserted a $0 under "ESA and 529 qualified tuition programs (Form 1099-Q).    Is this a program bug, or am I misunderstanding the deductibility of the distribution?

[Hal_Al · Accepted solution]

There's no bug and you do, generally, understand it correctly: a qualified distribution is not taxable.

But, the TurboTax (TT) interview is complicated, because the rules are complicated.

There's no actual "deduction" shown on the tax forms.  What happens, when the distribution is fully qualified, is that the earnings are "excluded" from the tax return. Nothing about the distribution shows up on the actual tax forms.

So, the simple thing to do is just don't enter the 1099-Q.  On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

But, you may actually want to pay some tax to take advantage of the education (tuition) credit.  Read on for more detail.

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Qualified Tuition Plans  (QTP 529 Plans)

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. 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. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

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 (usually on the student’s return)

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)

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip!  When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.

 ***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

[Carl]

1099-Q funds can be used for the qualified education expenses of tuition, books, and lab fees. Additionally those specific funds can be used tax exempt for the unqualified but allowed expense of room and board, provided that room and board was paid "in direct support" of the education.

So if those funds were used to pay room and board for the summer semester, but the student was not enrolled as a full time student for that semester, then room and board for that period is "NOT" tax free.

Finally, when you have a 1099-Q it is important that you work through the education section the way it is designed and intended to be used. If you do not, then chances are high that you will not be asked for room and board expenses and will therefore be "taxed" on 1099-Q funds that were used for room and board.

[Hal_Al]

The student only needs to be half time or more, for room & board to be a qualified expense for a 1099-Q.