529 Plan Distribution with scholarship

[rogerjbos]

My son has scholarships which covers about half of his educational expenses.  I took withdrawals from my 529 plan for the total amount (including scholarship).  I know I will have to pay tax on the excess amount, but I don't have to pay the 10% penalty because it is related to the scholarship.  I have no idea how to calculate the tax amount or how to report this in turbotax.  I filled out the form below with all the details.  Thanks in advance for any help.

Provide the following info for more specific help:

* Are you the student or parent. PARENT

* Is the student the parent's dependent. YES

* Box 1 of the 1098-T $29,105

* box 5 of the 1098-T $29,275

* 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 NO

* Box 1 of the 1099-Q $66,294.00

* Box 2 of the 1099-Q $40,684.59

* Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)? PARENT

* Room & board paid. $14,000

* Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers $300

* How much taxable income does the student have, from what sources ~$2,500

* Are you trying to claim the tuition credit (are you eligible)? YES

* Is the student an undergrad or grad student? UNDERGRAD

* Is the student a degree candidate attending school half time or more? FULL-TIME

[KrisD15]

It looks like you answered the interview questions properly,

HOWEVER, you say the student got scholarships that covered about half of the tuition, but if Box 1 is 29,105 (tuition paid to the school) and box 5 is 29,275 (scholarships that went through the school), Scholarships were MORE THAN tuition. 

Look at the student account records to see if any scholarship money crossed the calendar year. Sometimes schools bill in December but the scholarship post in January or scholarships post in December, but the school takes payment in January. 

SO working with your numbers, your student had 29,105 + 14,000 + 300 = 43,405 expenses less 29,275 scholarships = 14,130 expenses.

You take earnings 40,685 X  expenses 14,130 divided by distribution 66,294 = 8,672 tax-free earnings 

Earnings 40,685 less tax-free earnings 8,672 = 32,013 taxable earnings based on your numbers 

Also be aware that if you tell the program that you would like the credit (which is fine) the program might have the student claim scholarship income to free up expenses for your credit. 

IRS Pub 970 is not difficult to read (as far as IRS Publications go) and illustrates some great examples. 

The IRS wants you to get an education credit if possible. 

[ Edited 04/12/2024 I 1:24pm PST]

@rogerjbos

[Hal_Al]

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

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 American Opportunity Credit (AOC or AOTC) is 100% of the first $2000 of tuition and 25% of the next $2000 ($2500 maximum credit). 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 regardless of whose money was used to pay 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 which is only qualified for the 1099-Q)

   -$3000 paid by tax free scholarship***

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q (on the recipient’s return)

Box 1 of the 1099-Q is $5000

Box 2 is $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

There is  $1120 of taxable income (on the recipient’s return)

**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.

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." 

***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. Most people come out better having the scholarship taxable before the 529 earnings. A student, with no other income, can have up to $13,850 of taxable scholarship (in 2023) and still pay no income tax. 

[Hal_Al · Accepted solution]

You will have to pay the 10%  penalty on some of the distribution. Apparently, you added the scholarship on top of the expenses, in calculating how much to withdraw.  

Your expenses are $29,105 + 14,000 + 300 =$43,405. That's the most you could withdraw penalty free. 

You need $4000 of tuition to claim the credit. That leaves $39,405 of expenses for the scholarship and 1099-Q.

I assume the student’s $2500 of income is earned income from wages. We can make $11,350 (13850 – 2500 = 11350) of his scholarship taxable and he will still owe no tax.* He does not even need to file.

So, that means $17,925 (29,275 – 11,350 = 17925) of the expenses will be allocated to the scholarship. This is also the amount (not the full 29,275) that will be used in calculating the penalty exception

That leaves $21,480 (39,405 – 17,925 = 21,480) for the 529 distribution (1099-Q). 21480/66294 = 32.4% of the distribution is qualified; 67.6% is non-qualified. 0.676 x $40,685 (529 earnings) = $27,503 taxable income. It goes on line 8z of Schedule 1 as “Qual state (or private) tuition prgm from 1099-Q”

* Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement and the dependent standard deduction calculation (earned income + $400).  It is not earned income for the kiddie tax and other purposes (e.g. EIC).  For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.

____________________________________________________________________________________________

HOW TO ENTER ALL THAT IN TURBOTAX (TT)

If the student will be filing a tax return, the simple thing to do is enter the 1098-T with $11,350 in box 5 and $0 in box 1.

On your return,  It’s best to use a workaround.

Enter the 1098-T, at Educational expenses and scholarships with $4000 in box 1 and 0 in box 5. Enter no other numbers in that section. That gets you the American Opportunity (tuition) credit. 

Enter the 1099-Q, in ESA and 529 qualified tuition programs (1099-Q) section.  When asked who the student is answer: someone else not listed here (lying to TurboTax to get it to do what you want does not constitute lying to the IRS).  Enter the student's name when asked.  A few screens later, you'll get one simple screen to enter expenses. Press Done at the 1099-Q summary screen, to get there.

Enter $25,105 for tuition (21480 -14000 -300 +17925)  for tuition. Enter $14,000 for room & board and $300 for books. Also enter the amount ($17,925) of the scholarship in the box "Tax-free assistance".  This reports the earnings as taxable and claims the scholarship exception. You do not have to deal with the complicated “Educational expenses and Scholarships” (1098-T) section later. TT will prepare form 5329 to calculate the penalty (about $1650).

[rogerjbos]

Thank you for your reply.  Based on your reply, I was really confused at first and thinking there was something wrong with my 1098-T.  Box 1 does show only 29,105, but I looked again at the bills from the school and the total QEE was over $69,000, so I figured the amount in box 1 was after the scholarship value shown in box 5.  I checked my 1098-T from 2022 and it looks like some of 2023 expense was included there.  So I have to try to fix that to allocate it properly.

[AmyC]

The expenses paid during the tax year must be for an academic period that begins in the same tax year or an academic period that begins in the first three months of the following tax year from IRS Q & A

[rogerjbos]

Ok, reading through all the answers and updating my figures for the full year expenses, I have 69,380 in QEE.  If I subtract out 4,000 to get the full 2,500 AOTC, that leaves 65,380.  The scholarship was 29,275.  Since the tuition portion was around 45,000 of the QEE, can I assume the entire scholarship amount is tax free?

Assuming the scholarship is tax free, that leaves 36,105 of expenses.  My 529 distribution box 1 was 66,294, so that means it is 54.5% tax free and 45.5% taxable.  My 529 earnings box 2 was 40684.59.  So the taxable income on that would be 18,511 (40685 * 0.455).  So I can put that 18,511 on my son's tax return and pay the necessary taxes on that.

Please let me know if the above is correct.  Your prior answers have been extremely helpful!

[AmyC]

I would not.  I think you have things confused.  Any scholarship income not used on tuition is taxable. The tax on scholarship income is preferable to the 1099-Q. You want to reduce the 1099-Q as much as possible. Keep your paperwork showing how you did the math. If the scholarship has restrictions that it must be used on tuition, you must. Most scholarships can be used for living expenses and are much better for taxation.

Parent return: $65380 of expenses, Q is $66,294 so you have a very little taxable Q income on your return plus the education credit.

Student return:  the entire scholarship is taxable income. It may turn out that the education credit is not worth it by the time you add the extra income plus kiddie tax. See What is the Kiddie Tax?

[Hal_Al · Accepted solution]

Q. So I can put that $18,511 on my son's tax return and pay the necessary taxes on that?

A. No.  The 1099-Q is in your name (you are the recipient), so you can't report the earnings on his return. 

Furthermore, you don't want to.  Taxable 529 earnings are unearned income and the student does not get a full $13,850 standard deduction. The kiddie tax will kick in early. 

You first want to make $11,350(+/-) of his scholarship taxable (but not actually taxed) on his return to reduce the taxable portion of the 529 on your return.