Potential limitation in calculating AOTC credit when prepaid tuition 529 plan funds are used to pay tuition

[G-Whiz]

I believe that I have identified a limitation in the way TurboTax calculates qualified education expenses for the American Opportunity Tax Credit (and probably the Lifetime Learning Credit as well) when prepaid tuition 529 plan funds are used:

TurboTax (Deluxe) apparently does not consider distributions from prepaid tuition 529 plans as amounts that can't be used in Adjusted Qualified Education Expenses.  In fact, tax-free distributions from prepaid tuition 529 plans can only be used to pay for tuition and fees (whereas distributions from general 529 plans may also be used to pay for room and board, and school supplies.)  This limitation incorrectly allows filers to claim more AOTC credit than they may be entitled to.

In my situation, only $1,634 of expenses were eligible to be used to qualify for the AOTC; however, TurboTax calculated that I could claim up to the maximum credit (based on more than $4,000 of "allowed" expenses.)  I compensated for this limitation by itemizing entries on the Tax-Free Assistance line in the Student Info Worksheet form, and including as one item the amount of the prepaid tuition 529 plan distribution that should have been disallowed.

I suggest that TurboTax be modified to distinguish between general 529 plans and prepaid tuition 529 plans, and to correctly calculate the allowable AOTC due to each.

[Hal_Al · Accepted solution]

What is your reference for that opinion? It's not addressed in Pub 970.  Reading Pub 970, this user concludes that a pre-paid tuition 529 plan is treated the same as any other 529. 

Even if tax-free distributions from prepaid tuition 529 plans can only be used to pay for tuition and fees, that does not prevent you from declaring the distribution to be taxable and using the tuition to claim the American Opportunity Credit.  

TurboTax is doing that part correctly.  What it may  not be doing correctly (I haven't run a practice problem to test it) is allowing the user to allocate room and board and books and computers to the 529 plan.  I suspect (from reading Pub 970) that that is allowed. Even if not, it's not an area of enforcement with the IRS.

[G-Whiz]

Indeed, Pub 970 does not appear to distinguish between a prepaid tuition plan and other QTPs, so your view should be valid.  My understanding is based on the agreement of my plan (Private College 529 Plan by CollegeWell), which does not allow available funds to be used for anything other than tuition and mandatory fees.

If the IRS does not impose this limitation, then I believe that TurboTax is calculating "corrrectly" (that is, in line with IRS guidelines.)  This is good news, since it will allow me to claim more of the AOTC credit ... thank you for the insight!