529 Earnings Tax in Place of Lifetime Learning Deduction?

[magillmj]

My wife attended grad school, requiring $5650 in tuition. We paid part of this tuition using $5606 of 529 funds. The earnings on the 529 funds was $5.07, per our 1099-Q. Is it possible and legal to consider all of the distributions from the 529 account as "non-qualified expenses" and opt to pay the taxes on the earnings of the 529 account rather than reducing the amount of the Lifetime Learning Credit (LLC)? Or are we forced to reduce the Lifetime Learning Credit by the amount of 529 distributions? Reducing the LLC results in a smaller tax refund than if we were to pay income tax on the $5.07 worth of earnings on the 529 accounts. In prior years, our tax pro said we MUST reduce the LLC, but several sources and tax software platforms are stating we can choose how to combine the 529 distributions and LLC.

[Hal_Al]

Q.  Is it possible and legal to consider all of the distributions from the 529 account as "non-qualified expenses" and opt to pay the taxes on the earnings of the 529 account rather than reducing the amount of the Lifetime Learning Credit (LLC)?

A. Yes. In fact, it is encouraged.  If the 529 distribution is non qualified because the taxpayer elected to claim a tuition credit, the 10% penalty is waived. 

[magillmj]

Thank you for the quick reply @Hal_Al! Just to clarify, the full $5650 from our 1098-T should be entered on Form 8863, and the $6 earnings portion of the 1099-Q should be input as income on Schule 1, correct? No 10% penalty required since all of the $5060 529 funds were used for education and we are claiming education credit? Thanks again

[Hal_Al · Accepted solution]

Q. To clarify, the full $5650 from our 1098-T should be entered on Form 8863 and used to claim the Lifetime Learning Credit?
A. Yes.

Q. The $6 earnings portion of the 1099-Q should be input as income on Schedule 1, line 8z. Correct?

A. Yes. The description will be taxable portion of 529 distribution (or some such wording).

Q. No 10% penalty required since all of the $5060 529 funds were used for education and we are claiming education credit? 

A. Yes. The $6 goes on line 6 of form 5329 to claim the exception to the penalty.

[magillmj]

Thank you for your time and advice!

[rwing]

Hello, we are trying to use this strategy to maximize the LLC for our daughter. She has already used the EOC credit 4 times. Some of her tuition was paid for using her 529 funds. We want to elect for her to pay the tax on the 529 earnings so we can maximize the LLC. I can't find a way in the turbotax interview to receive the waiver on the 10% penalty, since the funds were used for qualified expenses. The forms mentioned in your response from last year are inaccessible, even using the forms tool.  Has it changed since last year? Is the penalty waiver already built in to the algorithm? Thank you in advance.

[Hal_Al]

@rwing 

The LLC is 20% of tuition, up to $10,000 and is non refundable. That is, it can only be used to reduce her tax liability. 

Is your daughter your dependent or can she be your dependent.  Is she a full time student. Was she under 24 on 12-31-24. Did she support her self with her own earned income.  That is, is she subject to the kiddie tax? If so what is your (the parent's matinal tax rate). If 22%+, this may not be a good strategy.  The 20% is applied to the full $10K.  The tax rate is only applied to the 529 earnings amount (box 2 of the 1099-Q).  Is the 1099-Q in her name/SS# or yours?

Theoretically, TurboTax can handle all this, automatically, but it doesn't always work. The workaround is:

Instead of entering the educational expenses in the education expenses section, enter it in the 1099-Q section of TT.  When asked who is the student, check "someone else not listed here" (Lying to TurboTax to get it to do what you want does not constitute lying to the IRS). On the next screen, enter the real student's name.  This will eventually give you one simple screen to enter all expenses. At the 1099-Q screen, check the box "The recipient is not Designated beneficiary". Press Done at the 1099-Q summary screen, to get to the expenses screen. 

After entering your expenses, enter the total expenses (or the amount used for the LLC , if less) in the box “Tax Free Assistance”. TurboTax will prepare form 5329 to claim the penalty exception, for the scholarship/tuition credit.