Q. Can TurboTax (TT) properly separate out up to $10,000 of earnings from a Section 529 Plan distribution that was used to pay qualified student loans and not tax those earnings?
A. Yes.
Q. TT doesn't offer anywhere to indicate the funds were used to pay student loans?
A. You should have been asked that question in both the 1099-Q section and the 1098-T section (if used).
The 1099-Q is only an informational document. The numbers on it are not required to be entered onto your (or your student's) tax return. The interview is complicated and it's easy to make mistakes. Avoid it if you can and you probably can.
You can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including student loan payments, up to $10K, 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 (you don’t need it). You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. You also cannot count expenses that were paid by tax free scholarships.
References:
- 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."
- IRS Pub 970 states: “Generally, distributions are tax free if they aren't more than the beneficiary's AQEE for the year. Don't report tax-free distributions (including qualifying rollovers) on your tax return”.
- "IRS Publication 970, Tax Benefits for Education states: If the entire 1099-Q went to qualified expenses, room and board, tuition, etc; then, you do not need to enter the form."
