Allocating excess 529 distributions between parent and student returns

[hillite]

Our son took classes in spring, summer, and fall semesters in 2024, all at the same university. 

For spring semester we (parents) paid the school $9,000 from our checking account.  For summer semester we also paid the school $7,000 from our checking account.  For fall semester we issued an $11,000 payment directly to the school from our son's 529 savings account (I am the owner, he is the beneficiary).

Our son received a 1099-Q from the 529 plan for $11,000.  My wife and I reimbursed ourselves from the 529 account so we received a 1099-Q from the 529 plan as well; however, ours was for $25,000 because I inadvertently reimbursed ourselves twice for the $9,000 payment.  (Not very smooth on my part.)  This results in an excess distribution.  

The excess distribution is made even greater by the fact that our spring semester payment was drawn from our checking account in late December, 2023 but not received by the institution until early January, 2024.  (Again, not one of my better moments.)  So I have spring semester money coming out of the 529 account in 2024 but the corresponding qualified expenses do not appear on his 2024 1098-T; the 2024 1098-T reports $20,000 of qualified expenses.

I have done the proration of earnings calculation to determine how much is taxable ($6,000).  Can all of this be reported on his return?  It would make more sense to have it taxed there, of course, as compared to our return.  (If it is taxed on his return, it would be pretty much a wash whether he does or doesn't take the non-refundable AOTC once we factor in the loss of the $500 dependent credit on our return.)

Or because our distribution exceeds the amount reported on the 1098-T do I have to allocate some or all of the taxable earnings as income to my joint return with my wife?  (I would guess that a return with distributions exceeding qualified expenses but claiming no additional taxable income might raise some IRS eyebrows.)  

What are the rules for how excess distributions can/cannot be allocated between parent and student returns when each of them received 1099-Qs?

[Hal_Al]

Q. I have done the proration of earnings calculation to determine how much is taxable ($6,000).  Can all of this be reported on his return? 

A. No. Because you were the recipient of the 2nd distribution (your name & SS# are on the 1099-Q), the taxable part of the earnings on that 1099-Q must go on your return.  His 1099-Q must go on his return.

Q. What are the rules for how excess distributions can/cannot be allocated between parent and student returns when each of them received 1099-Qs?

A. You are free to allocate expenses for the best outcome (although there may not be much difference since the distributions came from the same plan in the same year).  You are not locked in to the expenses that each distribution actually paid. 

Q. What about the AOTC?

A. It sounds like you're not eligible (income too high). Yes, if you forego claiming him as a dependent (and lose the $500 credit), he can use the non refundable portion on his return. This is worth up to $2500 (AOTC shifts to all non refundable). The "kiddie tax" will apply. The 10% non qualified distribution penalty will apply. The AOTC cannot be used to offset the penalty (only the actual tax). 

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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 $14,600 of taxable scholarship (in 2024) and still pay no income tax. 

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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 your1099-Q
• Box 2 of your 1099-Q
• Box 1 of his1099-Q
• Box 2 of his 1099-Q
• Room & board paid. If student lives off campus, what is school's R&B on campus charge. If he lives at home, the school’s R&B “allowance for cost of attendance” for student living with parents.
• 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?
• Is the student a degree candidate attending school half time or more?

[hillite]

Thank you for the reply - it's very helpful. 

Putting this all together, am I correct that we can do the following?

1) Allocate all $20,000 of the 1098-T expenses to the parents' return.  Since distributions to the parents totaled $25,000, 20% of the earnings on the parents' 1099-Q are taxable.  Report that on the parents' return and pay tax and penalty on those earnings there.

2) Since there are no expenses left to allocate to the student's return, 100% of the earnings reported on his 1099-Q are taxable.  Report those on his return and pay tax and penalty on them there.

You are correct that we are income-disqualified from taking the AOTC.

[Hal_Al]

Yes, you CAN do it that way.  

You previously said "If it is taxed on his return, it would be pretty much a wash whether he does or doesn't take the non-refundable AOTC once we factor in the loss of the $500 dependent credit"

That depends on the numbers. The AOTC is 100% of the first $2000, even when it's no refundable.  The taxable portion of a 529 distribution is unearned income. As such, it is subject to the "Kiddie tax" and he only gets a $1300 standard deduction. 

Whether there is any scholarship money or other income also affects then calculation. 

[hillite]

My previous analysis (that it would be pretty much a wash with or without the AOTC) was assuming that we could push 100% of the excess distribution (ie, both from his 1099-Q and ours) to his return.  Thanks to your explanation I now realize I can't do that.  So the scenario I asked about in my last post involved pushing as much of the taxable income as possible to his return by allocating all of the qualified expenses to ours.  But that would produce for him about $4900 of unearned income (plus another $25 of interest earnings from his bank account) against only $2800 in earned income.  (He has no other sources of income, scholarship or otherwise.) 

I've never dealt with the kiddie tax but have now researched it a bit. My gut tells me I would like to avoid that complication if possible, perhaps even if it costs us some money.*  But maybe it's not that bad.  It looks like the kiddie tax only applies if he is required to file a return.  The Interactive Tax Assistant on the IRS website tells me, after I answered a bunch of its questions, that assuming we use the first $4900 of 1098-T expenses to wipe out his share of the excess distribution he is not required to file a return.  If he did file a return in this scenario he would have no liability (his bank interest is less than $450) but he would get no refund because no federal income tax was withheld from his wages (although state and local taxes were).  Of course, if we go this route, we maximize the amount of excess distributions taxed on our return at a higher marginal rate.

On the other hand, it looks like if we get his total unearned income to $2600 or less (by allocating some of the excess distributions to his return) we avoid the kiddie tax - is this correct?  In that case, he would file a return, monetize the entire standard deduction (ie, the remaining $425), and we'd maximize the amount of excess distribution taxed at his lower marginal tax rate without triggering the kiddie tax.  Do I have this right?

Finally, if we do find ourselves in kiddie tax land:  we maximize the excess distribution taxed at his lower rate but expose a bunch of his earned income to tax because his standard deduction drops to $1300.  Further, I have to get acquainted with Form 8615 and await whatever other surprises it has in store for me.  Do I also have this right?

And each of the three scenarios above could be further complicated by whether he claims the AOTC.

Thanks again for the guidance. 

*I'm kinda past the point of trying to optimize my tax savings to the last dollar.  I just want to get in the ballpark, making sure I have a compliant return and not leaving a bunch of money on the table.  This is now my 7th tax year of dealing with education expenses and I'm clearly still wrestling with how to properly manage the transactions and calculate my liability correctly; you're right - it is complicated.  I'm questioning whether the financial benefits we've realized are worth the time I've spent over the years.