How does TurboTax know if loan payment was done using 529 funds? Also, why are 529 earnings taxed?

[TaxHead]

In the Education section, I entered 1099-Q first and then 1098-T. Though there was a check box in the step-by-step that asked whether 529 funds were used to pay loan, there was never a request for amount. So, how does Turbo tax know how much of 529 funds were used to pay loan? Because this amount should be used for the tax break. Also, I see earnings reported on this form. Shouldn't this be tax free? Is Turbo Tax treating it as such? 

Hopefully, I make sense. Otherwise, please notify me by replying to this message.

[Hal_Al]

Q. How does TurboTax (TT) know if loan payment was done using 529 funds?

A. You have to tell TT that.  It will ask that question in the 529 and 1098-T interviews.  When you answer yes, you get a box to enter the amount. 

Q.  Also, I see earnings reported on this form. Shouldn't this be tax free? Is Turbo Tax treating it as such? 

A. TT will treat it as tax free, after you enter all your expenses.  Right now there is a glitch preventing you from entering room and board expenses. We have been notified that the fix date is Friday.

But, better yet:

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 room & board (even if he lives at home) or loan payments (up to $10,000 lifretime) 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:

1. 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." 
2. 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”.
3. "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." 

[TaxHead]

I have run the step-by-step several times and haven't seen a place where it asks whether loan amount was paid using 529 funds. There is a generic question - Was any of the loan paid using 529 funds, but no question that asks the specific amount

[DaveF1006]

In this case, the easiest way to handle 1099-Q is not to enter it at all. You know you had qualified expenses to cover the distribution. This was a suggestion made by my colleague @Hal_Al and I concur with his advice.

The 1099-Q is only for record keeping if it's not taxed.  Expenses (including room and board) to cover the distribution, as the 1099-Q are generally used only for record-keeping if it's not taxable.

Perhaps the  reason why you are being taxed on earnings is that you entered the 1099 Q first before the educational expenses. If you entered the education expenses first and then the 1099-Q, the program may recognize you have enough educational expenses to offset the earnings from the 1099 Q.

If you are adamant about entering the 1099 Q, delete it completely from the return. Close the return to save the change.  open the return back  and reenter the 1099 Q to see if this makes a difference.

@TaxHead