How taxable scholarships affect 529 QEE

[Majk_Mom]

@Hal_Al ,

I’m still not clear on whether taxable scholarships our student reports as income increase the qualified portion of our 529 distribution or reduce it – depending on whether we took a 529 reimbursement for some of the taxable scholarship total, or didn’t take a 529 refund.

Tuition is 100% paid with a restricted scholarship (no impact).
$766 in fees go to AOTC (< $4K fees & supplies), the rest aren’t required for attendance and count as 529 NQEE together with living expenses: $1,578 in 529 non-qualified expenses.
R&B = $12,056

One $2K unrestricted scholarship we reclaimed from the 529 – after it was applied to R&B on direct bill. Can we still count this (if paying taxes on it) toward allowed 529 expenses (R&B)? So does that increase 529 QEE out of $14,693 total distribution? (Or reduce it?)

Another ~  $2K unrestricted scholarship we took as a refund direct from the college and applied to living expenses. If taxed on it, does this increase or reduce our 529 QEE out of total distribution? 

I assume both scholarships are fully taxable. Right now I have $11,946 as 529 QEE, and $2,747 as 529 NQEE, but I haven’t factored in the second scholarship.

Also, since our kid has tax-free scholarship more than triple the amount of 529 NQEE, I assume there's no 10% tax penalty on 529 NQEE?  Thanks for your help!! 

[Hal_Al]

Q. One $2K unrestricted scholarship we reclaimed from the 529 – after it was applied to R&B on direct bill. Can we still count this (if paying taxes on it) toward allowed 529 expenses (R&B)?

A. Yes.  Look at it this way: for QEE accounting, the taxable scholarship didn't pay for anything. It's just income. You're free to allocate $2000 R&B to the 529 distribution. It's a qualified expense for the 529 distribution. 

Q. So does that increase 529 QEE out of $14,693 total distribution?

A. Increases it.  

Q. Another ~  $2K unrestricted scholarship we took as a refund direct from the college and applied to living expenses. If taxed on it, does this increase or reduce our 529 QEE out of total distribution? 

A. Increases it. Because the $2k  is taxed, it's only income. It does not have to be allocated to any expenses at tax filing time.

Q. Also, since our kid has tax-free scholarship more than triple the amount of 529 NQEE, I assume there's no 10% tax penalty on 529 NQEE?  

A. Yes.  But, better yet, just allocate the expenses to the 529 distribution, not the scholarship taxable income.

[Majk_Mom]

Thanks for your responses. Still not tracking with your last comment. 

Q. Also, since our kid has tax-free scholarship more than triple the amount of 529 NQEE, I assume there's no 10% tax penalty on 529 NQEE?  

A. Yes.  But, better yet, just allocate the expenses to the 529 distribution, not the scholarship taxable income.

Please confirm:

So, are you saying taxable scholarship is just income, so we can use it for whatever we want and simply report it and it increases our 529 QEE? (Thus it helps reduce the corresponding total of our non-qualified expenses?) 

I'm not sure what you mean by "just allocate the expenses to the 529 distribution," when we have no other expenses that are 529-allowed expenses. In essence, we are using the first $2K scholarship to cover meal plan costs (if allocating it to any one allowed expense matters), but the only other expenses we have are all housing or food costs above the school's COA, etc. So does the second $2K scholarship simply reduce that NQEE  total? 

And how does this relate to the 10% tax penalty? 

So would I assume my 529 QEE total from earlier stays the same, but my NQEE total is reduced to $747 after allocating the 2nd taxable scholarship. Is this right? 

[Hal_Al]

@Majk_Mom  said  "the only other expenses we have are all housing or food costs above the school's COA".

Then you cannot allocate those costs to the 529 distribution.  As you appear to know, your qualified living expenses is limited to your actual costs or the school's  allowance for "cost of attendance" (COA), whichever is less.  But, that also means that scholarships did not pay for "qualified" living expenses and cannot be used for the penalty exception. 

Q. So, are you saying taxable scholarship is just income, so we can use it for whatever we want and simply report it and it increases our 529 QEE? 

A. Yes, but subject to the COA limit.

Q. How does this relate to the 10% tax penalty? 

A. Expenses that exceed the COA were not  "qualified" living expenses and cannot be used for the penalty exception. 

Q. So would I assume my 529 QEE total from earlier stays the same, but my NQEE total is reduced to $747 after allocating the 2nd taxable scholarship. Is this right? 

A. Yes, assuming the $747 is the amount living expenses exceed COA. 

[Majk_Mom]

Sorry for the follow-ups. I find this very confusing. First, I thought if tax-free scholarships (full tuition) prevented students from having enough qualified expenses to fully use their 529 funds that, so long as the total of non-qualified expenses was less than the tax-free scholarship total, those non-qualified expenses would be exempt from the 10% tax penalty (but not tax on earnings for that NQEE). So if we use 529 funds to pay for furniture/health costs/non-required fees that exceed the approved categories for basic QTRE or Housing COA or Food COA, then we must pay the 10% penalty + tax on earnings both? 

The official COA includes transportation, miscel. living expenses, health fee, and other non-allowed 529 expenses, so I'm not sure if that changes things. Much higher (~ $30K) than the Food/Housing COA total I was using.) 

Also, my original NQEE total is $2,747. The second $2K scholarship was refunded/used to cover some of our NQ expenses. We did not take an equivalent 529 withdrawal for $2K – like we did for the 1st scholarship. But we took the balance we needed (~$1K) to meet remaining NQ expenses. So that taxable $2K does not increase our 529 QEE or reduce our 529 NQEE? ($2,747 – $2,000 = $747 is incorrect?) It has no effect since we have no more 529-allowed QEE (other than the ~$12K I noted earlier) to allocate it to? (Unless the tax-free scholarship total figures in, but that must reduce our QEE total to avoid double dipping?) 

Thanks for breaking it down for me. 

[DaveF1006]

Yes, here are the answers to your questions:

1. Furniture, health insurance, and transportation are never QHEE for 529 purposes, even if they are in the school's "Official Cost of Attendance"(COA).  These are non-qualified distributions, thus earnings are taxable income  
2. Yes, by making the scholarship taxable, you avoid "double-dipping" rules, which saves $2,000 of your Tuition/Fees to be "covered" by the 529 plan instead.

Please reach back if you have further questions.

[Majk_Mom]

@Hal_Al 

A huge thanks for your help and expertise. I finally get it. Paying tax on scholarships not used for QTRE does not automatically convert 529 NQEE to QEE or offset NQEE necessarily, unless those taxable scholarships have actual expenses (R&B under COA in our case) they can be allocated to. (Which makes them 529 QEE). I've read so many things about tax-free scholarships taking away the 10% tax penalty on NQ distributions, but that only happens if they are partial QTRE scholarships and there is still remaining tuition or fees to which taxable scholarships can be allocated. (This explains the "paying tax" to qualify a full $4K in AOTC expenses.)  Again, thanks.