529 Plan Daughter (dependent) filing her own return, 1099-Q distributions match 1098-T qualified expenses, but TT still computes tax liability?

[mcelmell1]

@Hal_Al 

I have searched high and low for an answer, including testing various scenarios on TurboTax, but still confounded. Here's the situation...

My daughter is in college, out of state. She is the beneficiary of a 529 Plan. I (the parent) am the owner of the 529. I have already used TT (Premiere) to file our taxes, but my daughter still needs to file her tax return (she has excess of $13k in W-2 income), and will be using the Online version of TT to do so. My daughter received a form 1099-Q (for Tax Year 2022) which correctly details the amount of distributions from the 529 Plan and paid directly her school. She also has a form 1098-T, which details the amount of Qualified Tuition and Related Expenses.

Before my daughter files, I am using TT Premiere to "practice" by entering the numbers from the 1099-Q and the 1098-T forms. The two values (gross distribution reported on 1099-Q and qualified education expenses reported on 1098-T) differ by an amount that accounts for the Room and Board expenses plus a little bit more. After plugging in the Room and Board expenses into TT, it shows that my daughter still owes taxes toward the Federal return, but she should receive a refund for her State (California) return. We are happy about the refund for the state return, but no so for the Federal return.

In other posts here, on similar topics, I have read that sometimes TT makes errors on this calculation. Also, I have read that it may not be necessary to report the 1099-Q when filing. This worries me a bit, since it seems to be a red flag if the information on the 1099-Q is reported to the IRS. Can anybody in the community speak to that?

Here are the particulars of my situation...

Regarding forms 1099-Q and 1098-T

• Are you the student or parent. Student. 1099-Q shows my daughter's name and SS# 
• Is the  student  the parent's dependent. Parent's dependent.
• Box 1 of the 1098-T $20,677.71
• box 5 of the 1098-T (Blank - no scholarships or grants)
• Any other scholarships not shown in box 5 No
• Does box 5 include any of the 529/ESA plan payments (it should not) No
• Is any of the Scholarship restricted; i.e. it must be used for tuition N/A
• Box 1 of the 1099-Q $26,083.03
• Box 2 of the 1099-Q $19,494.10
• Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)? Student
• Room & board paid. If student lives off campus, what is school's R&B charge. $5329.00
• Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers None.
• How much taxable income does the student have, from what sources $13,279, from two W-2's (one job in California, one job in Colorado)
• Are you trying to claim the tuition credit (are you eligible)? No.
• Is the student an undergrad or grad student? Undergrad (full time)

Note: After combining the QTP expenses (Box 1 of 1098-T, $20,677.71) with Room & Board expenses ($5329.00), the total is $26,006.71. This is less than the amount shown in Box 1 of 1099-Q ($26,083.03), the difference being $56.32. Interestingly, when I checked my daughter's university account via the school's Financial Services website, she shows a credit of $56.32...the exact same amount. Not sure why the credit exists there, instead of the 1098-T, but it seems to point to sound accounting at the university, down to the penny!

According to my "practice" attempt on TT Premiere...

• With the 1099-Q and 1098-T information entered, my daughter owes $575 (federal), and should receive a refund of $199 (state, California).
• If we don't enter 1099-Q or 1098-T, my daughter should receive a refund of $190 (federal), and $81 (state).
• So, it appears that for federal, TT is computing ($575 + $190 😃 $765 taxes owed if she reports the 529 Plan distributions and QTP expenses (which seem to match). This is not the result we are hoping for from a 529 Plan. The plan should not increase her taxes as long as the distributions match the qualified expenses.
• For state, TT is computing $199 refund if we report the distributions and expenses, but only $81 refund if we don't. The difference is ($199 - $81 😃 $118...she would lose this amount if she did not report the 1099-Q and the 1098-T + Room & Board. Again, this does not make sense.

So, a few questions...

Q1: Is it okay for my daughter to simply NOT report the 1099-Q and the 1098-T?

Q2: If so, does this pose a risk or raise a red flag with the IRS?

Q3: Is this likely an error with TurboTax? Or, am I at fault by missing something in my data entry?

By the way, neither of us (myself or daughter) are taking the AOTC (American Opportunity Tax Credit).

Thanks in advance for any advice.

[TeresaM]

It depends.  It sounds as if you did not claim your daughter on your return, and the distribution was sent directly to the school to pay for tuition, so the Form 1099-Q came to her. This means it is all on her return, so well done planning that part. If she is not claiming an Education Credit, then there is no reason to reserve some of the qualified expenses for a credit and they can all be applied to the distribution. 

Q1: Is it okay for my daughter to simply NOT report the 1099-Q and the 1098-T?
There are two schools of thought in reporting Forms 1099-Q and 1098-T if there is not tax liability because the qualified education expenses covered all of the distributions and scholarships. 
Some prefer to always file forms.
Some are fine holding the forms and if the IRS asks to see them, you can send them in then. If there is not a tax liability, then there would be no fines.
I think it comes down to how you and your daughter feel most comfortable. If the IRS did flag it, they might research her return before any refund, and send a letter requesting information.  If they don't receive the information within the timeframe stated in the letter, then they make an adjustment based on their existing information. 

IRS Publication 970 says on pages 50 and 51:
Expenses for room and board must be incurred by students who are enrolled at least half-time (defined later). The expense for room and board qualifies only to the extent that it isn't more than the greater of the following two amounts.
a. The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student. 
b. The actual amount charged if the student is residing in housing owned or operated by the school. You may need to contact the eligible educational institution for qualified room and board costs.

Q2: If so, does this pose a risk or raise a red flag with the IRS?
If you don't include the forms she might never hear from the IRS and if she does, as long as you are confident the qualified education expenses cover the distribution, it would be a matter of replying to their letter requesting information. It would not cause liability, so there would be no penalties or interest. 

Q3: Is this likely an error with TurboTax? Or, am I at fault by missing something in my data entry?
This is tricky section and it may just be that income and forms were entered in a different order and the room and board were not given as an option.

It is important to enter all the income, then the Form 1099-Q, and then the Expenses and Scholarships ( Form 1099-T section. 

If it is entered out of order, the system may be reserving $10,000 of educational expenses toward an education credit, either American Opportunity Credit or Lifetime Learning Credit.  

If room and board were paid from the 529 distribution, please go back through the Education Credit section and be sure those were entered.  That is not a qualifying expense for the Education credits but can be used with 529 funds (subject to limitations). 

 
It may be that entering the information in this order will resolve the disparity between distribution and expenses.
If it does not, please do let us know what changes and what did not, and we are happy to research further. 

[Hal_Al]

Q1: Is it okay for my daughter to simply NOT report the 1099-Q and the 1098-T?

A1. Yes, if you know none of the 1099-Q is taxable.  Both documents are only informational and there is no requirement to enter them on your tax return.

Q2: If so, does this pose a risk or raise a red flag with the IRS?

A2. No. When none of the 1099-Q is taxable, nothing about it is sent to the IRS with your tax return. The risk is the same either way.

Q3: Is this likely an error with TurboTax? Or, am I at fault by missing something in my data entry?

A3. I can't tell. You talking about her refund and total tax liability instead of concentrating on the 1099-Q calculation. 

But, it does appear that a very small portion of the 1099-Q is taxable:

$26,083 (529 distribution) - $26,007 (QEE-qualified educational expenses) = $76 non qualified distribution.

76 / 26083 =0.29% of the earnings are taxable

0.0029 x $19,494 = $57 of taxable income.  This should be showing on line 8z of Schedule 1. In addition to the tax, there will be a 10% penalty (0.10 x 57 = $6). The penalty shows on form 5329

Better yet, come up with $76 more expenses and do not enter the 1099-Q.

I assume you are not claiming the tuition credit because you income is too high. You do not have to forego claiming the credit just because all the expenses were paid by the 529 plan. Allocate $4000 of tuition to the credit and have the student pay more tax on the 529 earnings.  Depending on your tax rate (the "kiddie tax" applies), the family comes out $1700 - $2100 ahead. The 10% penalty does not apply, because you claimed another tax attribute. Your daughter is not eligible for the AOTC on her return.*

*Technically, she can claim a nonrefundable credit, but that requires you to forgo claiming her as a dependent and the $500 dependent credit.  The math doesn't work out  in your case. 

[mcelmell1]

Thank you so much for your detailed reply. This has been a long, confusing journey and your advice brings clarity to our situation.

Regarding coming up with $76 more in expenses...I think we can do that! Daughter's Room & Board expenses, $5329, was paid to the college since she lived in the dorms on campus for the first half of the year (Spring semester). When she returned to school for the Fall semester, she moved into an off-campus apartment. None of that R&B money appears in the 1098, but I have receipts and records.

Between my wife and myself (filing jointly), our income is somewhat high, so I don't think we even qualified for the Tuition Credit. It did not come up in TT when I prepared our tax return, and I have already filed. At this point, I don't think I would want to file an amendment.

Do you have any suggestions for the current tax year, 2023, regarding claiming or not claiming our daughter as a dependent? This is new to me, and I am not sure how to navigate the "Dependent" question. She is turning 21 in May, and is expecting to graduate by December 2024. My wife and I are trying to let her take on more responsibility (living with college roommates, out of state), and to experience the reality of going to school, earning a living, and paying taxes. Of course, we will provide a safety net if she finds herself in financial trouble. Just wondering if it would make sense to NOT claim our daughter as a dependent and then she could possibly reap the benefits of the AOTC and/or other tax advantages next year. I'm not sure where the trade-off is.

Q1: If we (my wife and I) do not claim our daughter as a dependent on next year's taxes, we would likely lose out on some tax breaks, but would that result in certain advantages for our daughter?

Q2: If so, would it be a by a long shot? (Probably difficult to answer this without knowing our tax situation, but just asking in general.)

Thanks again!

[Hal_Al · Accepted solution]

Q. If we (my wife and I) do not claim our daughter as a dependent on next year's taxes, we would likely lose out on some tax breaks?

A. You lose the $500 Other dependent Credit.  The income limit for the tuition credit is $180K Married filing jointly.  It's worth $2500. 

Q. But would that result in certain advantages for our daughter?

A. No. She's not eligible for the tuition credit*.  With the tax law change, effective 2018, most students will get the same refund whether they claim themselves or not. The personal exemption has been eliminated and the standard deduction increased. 

Q. Will our daughter still qualify as a dependent for 2023 & 2024?

A. Yes, most likely. 

There are two types of dependents, "Qualifying Children"(QC) and Other ("Qualifying Relative" in IRS parlance even though they don't have to actually be related). There is no income limit for a QC but there is an age limit, student status, a relationship test and residence test.

A child of a taxpayer can still be a “Qualifying Child” (QC) dependent, regardless of his/her income, if:

1. He is under age 19, or under 24 if a full time student for at least 5 months of the year, or is totally & permanently disabled
2. He did not provide more than 1/2 his own support. Scholarships are excluded from the support calculation
3. He lived with the parent (including temporary absences such as away at school, even living off campus) for more than half the year

So, it doesn't matter how much he earned. What matters is how much he spent on support. Money he put into savings does not count as support he spent on himself.

The support value of the home, provided by the parent, is the fair market rental value of the home plus utilities & other expenses divided by the number of occupants.

*While technically there is a provision that allows your student-dependent to claim a federal tuition credit, from a practical matter it seldom works out.  A student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he/she supports himself by working. She cannot be supporting herself on student loans & grants and 529 plans and parental support.  It is usually best if the parent claims that credit.  
If the student actually has a tax liability, there is a provision to allow him to claim a non-refundable tuition credit. But then the parent must forgo claiming the student as a dependent, and the $500 other dependent credit.  The student must still indicate that he can be claimed as a dependent, on his return. This is worth up to $2500 (AOTC shifts to all non refundable)

[mcelmell1]

Thanks again for your follow-up reply. Working with my daughter, we have finalized her tax return without reporting the 1099-Q and the 1098-T, and she is due for a pretty decent refund.

I am retaining all related documentation, and in the event the IRS needs more information, we will be ready to present it.

Also, I will likely continue to claim my daughter as a dependent, at least until she is finished with college.

With much gratitude...