529 Distribution Offset By Scholarship, Parent 1099-Q

[sgt-loudmouth]

We took a 529 distribution based on the "scholarship exception." (The exception that say you can withdraw up to the amount of a tax-free scholarship and use the money for any purpose penalty-free.) The distribution showed up on the parent's 1099-Q, despite the fact that the 529 plan mailed the check to the student and in the student's name!

I'm going to call the plan and whine, but I don't expect them to re-issue the 1099-Q.

Is there a way to offset that distribution on the parent's return by the amount of the scholarship?

[DavidD66]

The exception for scholarship recipients who also have 529 plans allows funds to be removed from529 plans without penalty up to the amount of the tax-free scholarship.  You still have to report the gain on the distribution. If the distribution doesn't exceed the amount of the student's qualifying expenses, then you don't have to report any of the distribution as income on your tax return. If the distribution exceeds these expenses, then you must report the earnings on the excess as "other income" on your tax return.  If the student is your dependent, any gain should be reported on your tax return.  If the student is not your dependent, then the student should report the gain.  It doesn't matter if the distribution (1099-Q) sent to/in the name of the parent(s).  

[Hal_Al · Accepted solution]

@DavidD66  said "If the student is not your dependent, then the student should report the gain.  It doesn't matter if the distribution (1099-Q) sent to/in the name of the parent(s)". 

I disagree with that.  The 1099-Q is reported on the "recipient's" return.  The recipient is the  name and SS# on the 1099-Q.

Q. Is there a way to offset that distribution on the parent's return by the amount of the scholarship?

A. Yes, the TT interview theoretically handles this situation, but it's messy and easy to make mistakes. Here's a workaround:

Enter the 1099-Q. When asked who the student is, answer: someone else not listed here, whether he is you dependent or not (lying to TurboTax to get it to do what you want does not constitute lying to the IRS).  Enter the student's name when asked.  A few screens later, you'll get one simple screen to enter expenses. Also enter the amount of the scholarship in the box "Tax-free assistance".  This reports the earnings as taxable and claims the scholarship exception. You do not have to deal with the complicated “Educational expenses and Scholarships” (1098-T) section later. TT will prepare form 5329 to claim the penalty exception. 

[sgt-loudmouth]

Thank you!

[sgt-loudmouth]

Ha!  Contrary to my expectation, Fidelity fixed the forms 1099-Q.

It is a known system defect. If you make a 529 distribution to the plan beneficiary (the student) via EFT to the beneficiary's bank account, and you enter your request online, Fidelity *will* report the distribution on the participant's (the parent's) 1099-Q.

To fix the problem, you can call Fidelity when you receive the 1099s and ask them to recharacterize the EFT transactions to the beneficiary. 

To *prevent* the problem, request your distributions via TELEPHONE CALL instead of online. The agent's screens allow them to characterize the request as student or parent, whereas the online system treats all EFT as distributed to the parent.

[cactusjack]

Questions for Hal_Al or others  who know the answers (see below):

We (parents) also took a distribution after my son graduated, cashing out the 529 account.  The distribution was not used for college expenses.

Notes:

The 1099-Q has my name as the recipient.

- Gross distribution = $88K (Box 1)

- Earnings = $36K (Box 2)

- Basis = $52K (Box 3)

The 1098-T has my son's name as the recipient.

- Payments = $9670 (Box 1)

- Scholarships = $3700 (Box 5) 

Questions:

1) Given the information above, are we eligible to reduce taxes by including the scholarship amount shown?

2) Can you be more specific regarding "A few screens later" and where exactly to enter expenses?  After the "Who's the Student" screen and selecting "Someone else not listed here", I get the following:

(1) "Who's the the Student these expenses were paid for?" => entered my son's name

(2) "1099-Q Information" (reflects the information and boxes from the 1099-Q) => no changes or place to  enter expenses.

(3) "State Tuition Plan" => chose 'Nevada'

(4) "Death or Disability" => chose 'no' and 'no'

(5) "Distribution Transfer" => 'no'

(6) "Refund of Education Expenses" => 'no'

(end) Returns to "Form 1099-Q Summary" screen

3) Regarding the Earnings shown in Box 2 of the 1099-Q, why is this taxed as 'income' and not included in Capital Gains since this is from investment income?  For example, if my investments had a net loss of -$50K in 2022, why wouldn't the $36k in earnings be included with the -$50k for net loss of -$14K?   It seems odd that TT counts it as separate 'income'.

Thanks.

[Hal_Al]

1) Given the information above, are we eligible to reduce taxes by including the scholarship amount shown?

Showing the scholarship as "Tax free assistance" at the screen where you enter the expenses will help reduce the penalty for a non qualified distribution (the scholarship exception). The distribution and scholarship must be in the same year.

2) After it Returns to "Form 1099-Q Summary" screen, press done, you'll get more questions and the expenses screen. 

 3) Regarding the Earnings shown in Box 2 of the 1099-Q, why is this taxed as ordinary income  and not included in Capital Gains since this is from investment income? 

Because Congress said so.  The same argument could be made IRAs and 401k accounts.  You can not use your capital losses to offset the taxable portion of the 529 distribution. 

You say  "The distribution was not used for college expenses".  Yet, you indicate a 1098-T was received, showing tuition paid.   To claim some of the distribution as qualified, you did not literally have to use it for expenses.  The student only had to incur expenses, including room and board, in the same year as the distribution.  If the 1098-T was for 2021 and the distribution was in 2022 that doesn't count.

[cactusjack]

Thanks for the  quick response. Both the 1098-T and 1099-Q are for 2022.  My son graduated in April 2022, and we took the distribution for the remaining amount in September 2022.

On the screen for "Non-dependent student expenses", I've entered the following:

Tuition and Enrollment Fees = $9670

Tax-Free Assistance = $3700

My Federal Tax Due went down when I entered the $9670, but went up when I entered the $3700 (for a net reduction of around $1000 compared to before).

Is this correct?  I just want to make sure I'm not double-counting if this was already addressed in the 1098-T and 1099-Q.

Thanks again.

[Hal_Al]

Q. My Federal Tax Due went down when I entered the $9670, but went up when I entered the $3700 (for a net reduction of around $1000 compared to before). Is this correct? 

A. I can't verify the numbers, but yes the general effect is correct.

In addition to the tuition, you need to be entering an amount for room and board, even if lived at home.  You may claim your actual food & lodging costs or the school's allowance for on campus students, whichever is less.  If he had book and computer costs, those are also allowable expenses for a 529 distribution. 

Did you already claim the American Opportunity Credit (AOC) 4 times in the past, on your son's education? If not, the family may come out better if claims the AOC on his 2022 tax return.  If he does, he will use $4000 of tuition to do so and you will reduce your $9670 entry to $5670.  If you have claimed the AOC 4 times before, he is still eligible for the lesser Lifetime Learning Credit (LLC), but that will use all the tuition on his return and it'll be close who comes out better. 

[cactusjack]

It looks like we've only used the AOC three (3) times. Once in 2018 when he was still in high school, and again in 2019 and 2020.  I've used TT for the last 10 years straight, so I'm not sure why it didn't show up in the  2021 taxes, but will look into having him claim it on his 2022 return, along with adding the claims for food, lodging or the allowance as suggested.

Thanks again!