529 withdraw for scholarship earned not calculating tax correctly

[kbr25]

I have 2 daughters with identical situations (different numbers obviously) and turbo tax is treating them differently. We made a withdraw from each of their 529s in the amount of their scholarship for the year. Technically, they should both be taxed on the earnings of those withdraws. However, one is taxed and one is not. I went back and checked all the interview questions and i answered equivalently (again different numbers) for both of them. To simplify, we DO need to pay taxes on them because another relative actually pays their college tuition and because of the there is no other expenses to claim besides what is in box 1 of each of their 1098-Ts and those numbers are both larger than box 5 of their 1098-Ts (scholarship). The withdraws were for the exact amount of the scholarships. We also do not qualify for any of the other education credits. Also both 1099-Q have me as the recipient so need to go on my return. Although the calculations are in my favor, I am trying to be honest and not have an issue later. 

[Hal_Al]

The TurboTax (TT) interview is tricky and mistakes can be made.  

One possibility is that TurboTax allocated part of your dependent's college expenses to claim the Tuition credit, even if you are not eligible or otherwise did not claim it. That reduces the amount that can be used to claim the  529 earnings, shown on the 1099-Q.

 @kbr25  said  "we DO need to pay taxes on them because another relative actually pays their college tuition"

That's irrelevant.  Although the general rule, in taxes, is that you must be the one making the payment, to get the deduction, there is an exception for education. You may count all expenses, for the 529 distribution, even if paid by someone else.

@kbr25 said "because of the there is no other expenses to claim besides what is in box 1"

That's unlikely.  Room and board are qualifying expenses for a 529 distribution, even if the student lives off campus. Board (food) is a qualifying expense even if the student lives at home. Books, and even a computer (usually not shown in box 1 of the 1098-T) are qualifying expenses.

Having the student declare some of her scholarship taxable, on her return, can free up more expenses for you to use against the 1099-Q (assuming the scholarship money is not restricted to being used for tuition).

Provide the following info for more specific help:

• Are you the student or parent.
• Is the  student  the parent's dependent.
• Box 1 of the 1098-T
• box 5 of the 1098-T
• Any other scholarships not shown in box 5
• Does box 5 include any of the 529/ESA plan payments (it should not)
• Is any of the Scholarship restricted; i.e. it must be used for tuition
• Box 1 of the 1099-Q
• Box 2 of the 1098-Q
• Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)?
• Room & board paid. If student lives off campus, what is school's R&B charge. If the student lives at home, only the school's board charge for on campus students. 
• Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers
• How much taxable income does the student have, from what sources
• Are you trying to claim the tuition credit (are you eligible)?
• Is the student an undergrad or grad student?

[kbr25]

Thank you for trying to help. My biggest concern is that turbo tax is calculating the same situation (different numbers of course) differently for each of my 2 daughters. Also, we took the distribution from the 529 as "non-qualified" so i feel that I need to treat it appropriately  (paying the taxes) on our taxes so there is no trouble later.

in answer to your questions:

-i am the parent

-the students are both dependents

info for first daughter: this one turbo tax did not calculate that we owed taxes on

-box 1 1098t is 94292 

-box 5 1098t is 15000

-no other scholarships

-box 5 does not include 529/esa plan payments

-i dont believe scholarship is considered restricted although it goes directly to tuition (take off bill, we do not receive it, it is from the university)

-box 1 1099Q 15000

-box 2 1099Q 10365.56

-parent is the recipient

-not claiming tuition credit

-student is undergrad 

info for 2nd daughter-this one is saying we owe taxes on the earnings, which is correct

-box 1 1098t is 33600 

-box 5 1098t is 20062

-no other scholarships

-box 5 does not include 529/esa plan payments

-i dont believe scholarship is considered restricted although it goes directly to tuition (take off bill, we do not receive it, it is from the university)

-box 1 1099Q 20062

-box 2 1099Q 13675.50

-parent is the recipient

-not claiming tuition credit

-student is grad student

thank you for any help you can provide. My goal here is to have turbo tax correctly calculate both in the same way since situationally they are the same.

[Hal_Al]

Really, box 1 of the 1098t is 94, 292?

In that case you have sufficient expenses for the distribution and don't need to enter the 1099-Q, at all. 

What are your room and board, books and computers expenses?

[KrisD15]

Yes as @Hal_Al states, there are several working parts to the Education section. 

The distribution for Daughter 1 is not taxable. 

According to your numbers, she had over 94,000 expenses.

Even with 15,000 scholarship, there is more than enough expenses to cover the distribution. 

There would also be enough left in expenses to apply towards an Education Credit, unless you are not eligible because of some other requirement, such as income level. 

Daughter 2 has 33600 in tuition, less 20,062 in scholarships leaving 13,538 towards the distribution. 

If 20,062 goes straight to the school, and neither you nor the student gets a refund, I would assume the entire distribution is used for additional education expenses, such as Room and Board. 

This distribution should also be tax-free. 

@kbr25

PERHAPS you are confused as to "NON-QUALIFIED" expenses. 

For example, take Room and Board expense-

You may be allowed to allocate Scholarships to that expense, in which case the scholarship may be taxable income that the student must claim, 

HOWEVER 

a distribution used for Room and Board is NOT taxable.  

The expenses are handled differently (if taxable or tax-free) depending on the type of assistance used. 

[Edited 2/23/22 I 3:42pm PST]

[kbr25]

This is really confusing to me. If both distributions were taken from the 529 as "unqualified" shouldnt they both be treated the same way? Im not understanding how one has enough to cover the distribution and the other does not. However I still return to the "unqualified distribution" issue. We specifically took the amount out only of the scholarship, knowing we would pay taxes but not penalties. Separately, could we actually have taken a larger distribution?

Also daughter #2 did have separate room and board (daughter #1 r&B expenses are included in 1098t box 1), but since I when I made the withdrawl from the 529, i marked it "unqualified" couldnt this present a problem if I then enter that to eliminate the tax burden?

Also we do not pay the tuition. Another family member does so wouldnt it be "cheating"?

[KrisD15]

PERHAPS you are confused as to "NON-QUALIFIED" expenses. 

For example, take Room and Board expense-

You may be allowed to allocate Scholarships to that expense, in which case the scholarship may be taxable income that the student must claim, 

HOWEVER 

a distribution used for Room and Board is NOT taxable.  

The expenses are handled differently (if taxable or tax-free) depending on the type of assistance used. 

UNQUALIFIED means they may not be used for the Education Credit. 

No, it is not cheating, anything paid for the student is claimed by the taxpayer claiming the student. 

No, not a problem, enter the expense for Room and Board for daughter 2 and the distribution should not show as taxed. 

According to the IRS: FOR DISTRIBUTIONS

"These are expenses related to enrollment or attendance at an eligible postsecondary school. As shown in the following list, to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time. 1. The following expenses must be required for enrollment or attendance of a designated beneficiary at an eligible postsecondary school. a. Tuition and fees. b. Books, supplies, and equipment.

2. Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible postsecondary school.

3. Expenses for room and board must be incurred by students who are enrolled at least half-time (defined below). 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.

4. The purchase of computer or peripheral equipment, computer software, or Internet access and related services if it is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible postsecondary school. (This doesn’t include expenses for computer software for sports, games, or hobbies unless the software is predominantly educational in nature.)"

"Expenses paid by others. Someone other than you, your spouse, or your dependent (such as a relative or former spouse) may make a payment directly to an eligible educational institution to pay for an eligible student's qualified education expenses. In this case, the student is treated as receiving the payment from the other person and, in turn, paying the institution. If you claim the student as a dependent on your tax return, you are considered to have paid the expenses."

IRS PUB 970

[kbr25]

I truly appreciate your help. Im sure Im confusing everyone, as I am really confused myself (and usually have a pretty good handle on this stuff).

Let me see if I can clarify in hopes that you can help me understand.

Both girls school expenses (tuition, etc) are paid for by a grandparent. Therefore we do not write a check, have loans or anything from our end to the schools, so technically not our money/expenses.  We are trying to recoup the 529 money (I know can be saved for next generation, etc, but we had set it aside not knowing we would receive this "gift" so would like to be able to use towards other things.) Thus, we learned that we could take a non-qualified distribution in the exact amount of the scholarship and we would be taxed on the earnings but not have the 10% penalty (when we take the distribution from the 529 program, it specifically asks if its qualified expense or non-qualified and we said non-qualified) in the amount of the scholarship. 

I understand that daughter #1 seems to be covered and not have to pay the taxes, and that if I list room & board for #2, it may be her case as well, but Im trying to be on the up and up here and not test the system especially since the 529 program has it as a "non-qualified" distribution. Happy to be able to make it work and not pay the taxes, but also dont want trouble down the road. 

[KrisD15]

The Education Credit is an area where the IRS ENCOURAGES the Taxpayer to use whatever method gives them the best tax break. 

The IRS does not frown upon allocating expenses and payments to get the best return.

IRS PUB 970 has a lot of great information, examples and is pretty easy to read. It might be worth you looking it over. 

An example from IRS Pub 970:

"The American opportunity or lifetime learning credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses aren't used for both benefits. This means the beneficiary must reduce qualified higher education expenses by tax-free educational assistance, and then further reduce them by any expenses taken into account in determining an American opportunity or lifetime learning credit.

Example. Derek Green had $5,800 of qualified higher education expenses for 2021, his first year in college. He paid his college expenses from the following sources.

Partial tuition scholarship (tax free) ......... $1,500

Coverdell ESA distribution ............... 1,000

Gift from parents ...................... 2,100

Earnings from part-time job ............... 1,200

Of his $5,800 of qualified higher education expenses, $4,000 was tuition and related expenses that also qualified for an American opportunity credit. Derek's parents claimed a $2,500 American opportunity credit (based on $4,000 expenses) on their tax return. Before Derek can determine the taxable portion of his Coverdell ESA distribution, he must reduce his total qualified higher education expenses.

Total qualified higher education expenses .... $5,800

Minus: Tax-free educational assistance ...... − 1,500

Minus: Expenses taken into account in figuring American opportunity credit ....... − 4,000

Equals: Adjusted qualified higher education expenses (AQHEE) ................... $ 300

Since the AQHEE ($300) are less than the Coverdell ESA distribution ($1,000), part of the distribution will be taxable. The balance in Derek's account was $1,800 on December 31, 2021. Prior to 2021, $2,100 had been contributed to this account. Contributions for 2021 totaled $400. Using the four steps outlined earlier, Derek figures the taxable portion of his distribution as shown below. 1. $1,000 (distribution) × $2,100 basis + $400 contributions $1,800 value + $1,000 distribution = $893 (basis portion of distribution) 2. $1,000 (distribution) − $893 (basis portion of distribution) = $107 (earnings included in distribution) 3. $107 (earnings) ×    $300 AQHEE    $1,000 distribution = $32 (tax-free earnings) 4. $107 (earnings) − $32 (tax-free earnings) = $75 (taxable earnings) Derek must include $75 in income (Schedule 1 (Form 1040), line 8z). This is the amount of distributed earnings not used for AQHEE."

IRS PUB 970

"Off-campus housing

While investors can use 529 funds to pay for a college's room and board fees, housing arrangements off campus also count. "Off-campus housing and rentals are qualified up to the cost of room and board on campus," Hogan says. For instance, if university-owned housing is $800 per month, then the disbursement for an off-campus rental can't be more than that amount."

US NEWS

[Hal_Al]

Bottom line: both of  your student's distributions are qualified and you do not need to even enter the 1099-Q.

The 2nd daughter needs about $7000 of Room & board, books and computers to match the distribution.  Even if she comes up a little short, the worst case scenario she has to declare a small portion of he scholarship taxable to free up a few dollars  more of expenses for the 529 distribution. 

The fact that you told the plan administrator it was nonqualified does not lock you to calling it nonqualified at tax time. That was just informational for their records. It was not sent to the IRS.  You may want to contact them to change that, although I don't think it's necessary. 

The fact that the grandparents are paying is not relevant.  You get to count their money for tax benefits ( a tax free 529 distribution rather than the tuition credit, in your case). 

There's always  a risk of a IRS inquiry.  Every case we've seen, in this forum,  has been handle by the taxpayer showing that they had sufficient expenses.  It's been noted that such IRS letters, on 1099-Qs have dropped off  in recent  years.

_________________________________________________________________________________

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. 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. 

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." 

[taw2]

I have a similar situation.  We took a distribution for the merit scholarship amount from our 529 for our son.  Grandparents are paying for all of the expenses not covered by the merit scholarship (it covers only tuition) - however - they are using a 529 they created for our son.  Not sure how to enter it.  We recognize that we need to pay taxes on the 529 scholarship distribution we took.  We don't have an issue with this, but not sure how to enter expenses in Turbo Tax to reconcile this.

[Hal_Al]

@taw2  For your 529 plan distribution: You enter the 1099-Q first.  Later you enter the 1098-T with the same amount (as box 1 of the 1099-Q) in boxes 1 & 5 at the 1098-T screen. Don't enter any other numbers. If you encounter a  screen called "Amount used to calculate education deduction or credit", be sure the amount in that box is 0. 

That will make the amount in box 2 (earnings) of the 1099-Q taxable and TurboTax will generate form 5329 to claim the scholarship penalty exception.

If you run into a problem, delete the 1099-Q and 1098-T  and try this  workaround in TurboTax:

Enter the 1099-Q. 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 tuition. Also enter the amount 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 claim the penalty exception. 

[Hal_Al]

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

For 529 plans, there is an “owner” (usually the parent but in this case  also the grandparent), 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 $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.