Can someone explain why I am being taxed on a state funded pre-paid college plan and scholarship from my university?

[paigeramsey0126]

I only earned $2000 by working and am now looking at owing $1255 in taxes. My Fl pre-paid is applied directly to the university as is the university scholarship

[Carl]

I am expecting you to hvae a 1099-Q in your possession showing the distributions from the FL pre-paid plan. Do not confuse this with the Bright Futures scholarship program. Bright Futures has nothing what-so-ever to do with the pre-paid plan.

Just a wild guess at this point. But it sounds to me like you entered your scholarships and 529 distributions separately, when they were already included in box 5 of your 1098-T.  Also, understand these facts:

Colleges operate in academic years, while the IRS operates in calendar years. So the reality is, it takes you 5 calendar years to get that 4 year degree. With that said:

 - Scholarships, grants and 529 distributions are reported as taxable income *INITIALLY* in the tax year they are received. It *does* *not* *matter* what tax year that money may be *for*.

- Qualified education expenses are reported/claimed in the tax year they are actually paid. It *does* *not* *matter* what tax year is paid *for*.

Scholarships and grants can only be used to pay for the qualified education expenses of tuition, books, and lab fees. That's it. There are no exceptions.

529 distributions can be used to pay for the qualified education expenses of tuition, books, lab fees ***AND*** room and board.

It is "IMPERATIVE" that you work through the education section of the program the way it is designed and intended to be used. If you do not, then chances are extremely high that you will "NOT" be asked for room and board expenses and will therefore be taxed on your 529 distributions.

[Hal_Al · Accepted solution]

Q.  Can someone explain why I am being taxed on a state funded pre-paid college plan and scholarship from my university?

A. Yes.  Scholarships that are not used for qualified expenses are taxable.  You cannot use the same expenses to claim both the college plan and scholarships to be tax free. It's complicated.  Although TurboTax (TT) can handle it., it's easy to make mistakes.  And there are  alternative decisions to be made. 

See full explanation below.

Provide the following info for more specific  help:

• Are you the student or parent.
• If, student, are you the parent's dependent. 
• Box 1 of the 1098-T
• box 5 of the 1098-T
• Does box 5 include any of the prepaid plan payments (it should not)
• Box 1 of the 1099-Q
• Box 2 of the 1098-Q
• Room & board paid. If you live off campus, what is school's R&B charge
• Other qualified expenses, e.g. books & computers

_____________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Applicable to most prepaid plans

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 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 $600

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

60%x600= $360

You have $240 of taxable income (600-360)

**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.

 ***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.

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." 

[Carl]

All scholarships, grants and 529 distributions are reported as taxable income *INITIALLY*. their taxability is offset by the qualified education expenses they are used to pay for.

 First, scholarships & grants are applied to qualified education expenses. The only qualified expenses for scholarships and grants are tuition, books, and lab fees. that's it. If there is any excess, then it's taxable income. It automatically gets transferred to and included in the total on line 7 of the 1040.

Next, 529/Coverdell funds reported on 1099-Q are applied to qualified education expenses. The qualified expenses for 1099-Q funds are tuition, books, lab fees, AND room & board. That's it. If there are any excess 1099-Q funds they are taxable. The amount is included in the total on line 7..

Finally, out of pocket money is applied to qualified education expenses

When you have a 1099-Q it is extremely important that you work through the education section of the program in the order it is designed and intended to be used. If you do not, then there is a high probability that you will not be asked for room & board expenses, and you could therefore be TAXED on your 1099-Q funds.

Finally, if "all" qualified expenses are covered by scholarships, grants, 1099-Q funds and there is ANY of those funds left over, the left over excess is taxable. While the parent can still claim the student as a dependent, it is the student who will report all the education stuff on the student's tax return. That's because the STUDENT pays the taxes on any excess scholarships, grants and 1099-Q funds.