529 distribution penalty exception due to scholarship

[circle11]

Greetings! My daughter was awarded a full college scholarship and I have no younger children so I made a distribution from the 529 account (she is a beneficiary of that account).  I received form 1099-Q from Fidelity, my SSN is shown as a Recipient TIN on the form.  When I enter that form into TurboTax, I see that Schedule 2 Line 8 shows 10% penalty on the Earnings amount of the distribution. Questions:

1. I was told that in the case of scholarship I should be able to make penalty free distributions up to the amount of her scholarship per year. What IRS article covers that rule? 

2. More importantly, I read that I should be able to claim the penalty exception via form 5329. Where in TurboTax can I do that? That question does not come up during entering 1099-Q. 

Thanks in advance for your help!

[maglib]

@circle11  A 529 is broken up into 2 portions, the basis of your initial investment and the earnings portion.  The basis of the initial investment would only have potential tax consequences to a state if there were state tax benefits for saving in such states as NY.  The earnings which grow tax free though now that would be the tax consequences we need to discuss.

You may be confusing PENALTY vs. PAYING TAXES.  The only thing you may not have to pay is a PENALTY. Since the income grew tax free, you would have to pay taxes on the tax free growth.  

A 529 can be left and used by any relative, cousin, sister, kids, grandkids, etc and transferred over tax free to any others.

The Penalty is very small. it is 10% and only on the earnings portion.  THE ONLY EXCEPTIONS TO THE PENALTY:

In the following situations, the 10% penalty is waived for non-qualified 529 plan distributions, but the earnings portion of the distribution is subject to income tax:

• A beneficiary dies or becomes disabled
• A beneficiary receives a tax-free scholarship
• A beneficiary receives educational assistance through a qualifying employer program
• A beneficiary attends a U.S. Military Academy
• The qualified education expenses were used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC)

when you go through the 529 withdrawal interview Turbotax will ask you the questions and it will ask you questions related to the scholarship and the school expenses. Make sure you do the entire college interview in order and do not skip any sections and it should calculate everything correctly for you.  The penalty is now worse than if you had invested in after tax investments honestly.  

529 money grew tax free so all growth would now be taxable if the money was withdrawn and not used for college expenses.  To the extent you may have gotten and state benefits on a state return for investing in a 529 such as in NY, there also may be tax consequences.

NOTE A TAX FREE SCHOLARSHIP per the above rules IS ONLY THE PORTION OF THE SCHOLARSHIP THAT WAS NOT USED FOR ROOM AND BOARD.  Any scholarship used for room and board can be taxable income.

Section 6693 deals with IRS penalty. 

Some IRS notices and documentation on 529's:

https://www.irs.gov/taxtopics/tc313

https://www.irs.gov/irb/2003-33_IRB#NOT-2003-53

https://www.irs.gov/irb/2016-07_IRB#NOT-2016-13

I do not work for Turbotax.  I hope this was helpful.

[Hal_Al]

Q I was told that in the case of scholarship I should be able to make penalty free distributions up to the amount of her scholarship per year. 

A. Yes, penalty free but not tax free.  The box 2  (1099-Q) amount should be showing up as income on Schedule 1, line 8z.

Q.  I read that I should be able to claim the penalty exception via form 5329. Where in TurboTax can I do that? That question does not come up during entering 1099-Q. 

A.  That's correct, when entered properly, TT will generate form 5329 to claim the penalty exception.  Also correct, that you are not asked that in the 1099-Q interview.

After entering the 1099-Q, your must enter the 1098-T at the educational expenses section.  If the amounts in box 1 and box 5 cover the box 1 (1099-Q) amount, you should not need to enter any other amounts. Be on the look out for a screen called "Amount used to calculate education deduction or credit"   TT may have populated this with $4000 or 10,000.  Change it to 0.  See below for another option. The allocation of expenses will show on the Student information worksheet and the 1099-Q work sheet. 

Here's a quicker workaround (or if you run into a snag above). Rather than entering the 1098-T later: at the 1099-Q interview, when asked who the beneficiary is, answer someone not listed here. Then enter your daughter's name at the next screen.  That will get a you a simpler screen to enter expenses, in the 1099-Q interview.  There are several screens before you get there, including one asking for the level of school the student attended. After entering the expenses, be sure to enter the offsetting amount at "Adjustments: Tax-free assistance" (scholarships). 

____________________________________________________________________________________

A couple of other issues:

1. If the student has a scholarship that also pays for room and board, she has some taxable income.  Scholarships that pay for qualified expenses (tuition, fees, books nd other course materials including a required computer) is tax free.  But scholarships that pay for room & board and other personal expenses is taxable income to the student.  Room and board paid by the student's taxable income/scholarship is eligible for a 529 distribution. 

2. You may still be eligible for a tuition credit, even though all the expenses were paid by scholarship. 

There is a tax “loop hole” available. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents  (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship.  You cannot do this if the school’s billing statement specifically shows the scholarships being applied to tuition or if the conditions of the grant are that it be used to pay for qualified expenses.

Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.

[circle11]

@Hal_Al - Thank you very much for such a detailed answer - very helpful! I've actually talked to a couple of knowledgeable CPAs and both had not idea what I was asking and said they needed to research the question around scholarship and penalty free with withdrawals. One of them told me I'd have to enter my 1099-Q under her return which makes no sense whatsoever. 

Before I go any further, let me make sure I understand correctly. When you said "your must enter the 1098-T at the educational expenses section", I assume you mean entering her 1098-T (obviously it is issued under her name) into my tax return? Feels a bit weird entering her form under my return, or is that normal? 

Also (rounding these numbers for simplicity), on her 1098-T, box 1 amount is $27,000, box 5 amount is $19,000, and the 529K withdrawal I made was $20,000. Does that mean I will still be penalized on the excess $1,000 withdrawal? Obviously, not a big deal, just want to know for the following years.   

Just an fyi - I've created a separate TT account for her, entered her 1098-T, and the tax due amount came out as 0 (she has no income outside of this scholarship). I assume that means she does not have to file a return on her own? 

Thanks again!!

[circle11]

@maglib - Thank you very much, but I do realize there is difference between the penalty which hopefully I should not incur and the taxable earnings amount. 

Her scholarship does cover everything including room and board. I've entered her 1098-T into TT under her account and the tax amount came out at 0. So I assume the entire scholarship is tax free and she does not need to file a return on her own? 

[Hal_Al]

Q.  I assume you mean entering her 1098-T (obviously it is issued under her name) into my tax return? Feels a bit weird entering her form under my return, or is that normal? 

A . Yes and yes, that is normal.

Q.  Does that mean I will still be penalized on the excess $1,000 withdrawal?

A. No. There is no excess withdrawal because the withdrawal ($20K) is less than the expenses ($27K).

Q.  On her return, the tax due amount came out as 0 (she has no income outside of this scholarship). I assume that means she does not have to file a return on her own? 

A. Probably. But you don't say how much of the scholarship is taxable.  From your rough numbers, none of it should have been taxable ($27K tuition > $19K scholarship)

What you haven't asked about is how much of the 529 distribution is taxable.  It's not the $20K or even $19K.  The maximum taxable amount is the amount in box 2 of the 1099-Q (the earnings).  But it will be something less than that.  Theoretically TurboTax (TT) will calculate that for you and place it on line 8z of Schedule 1.  But, the interview is tricky.  It helps of you have an idea of the outcome. See example below.

______________________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by tax free scholarship***

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q (usually on the student’s return)

Box 1 of the 1099-Q is $5000

Box 2 is $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

**Alternatively; 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) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip!  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, in case of an IRS inquiry.

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." 

***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit. Most people come out better having the scholarship taxable before the 529 earnings. 

[Hal_Al]

Provide the following info for more specific help:

• Are you the student or parent.
• Is the  student  the parent's dependent.
• Box 1 of the 1098-T
• box 5 of the 1098-T
• Any other scholarships not shown in box 5
• Does box 5 include any of the 529/ESA plan payments (it should not)
• Is any of the Scholarship restricted; i.e. it must be used for tuition
• Box 1 of the 1099-Q
• Box 2 of the 1098-Q
• Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)?
• Room & board paid. If student lives off campus, what is school's R&B charge. If the student lives at home, only the school's board charge for on campus students. 
• Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers
• How much taxable income does the student have, from what sources
• Are you trying to claim the tuition credit (are you eligible)?
• Is the student an undergrad or grad student?

[circle11]

Are you the student or parent.

-- Parent

Is the  student  the parent's dependent.

-- Yes

Box 1 of the 1098-T

-- $18,812 (again, 1098-T is under my daughters name)

box 5 of the 1098-T

-- $27,316

Any other scholarships not shown in box 5

-- No

Does box 5 include any of the 529/ESA plan payments (it should not)

-- No

Is any of the Scholarship restricted; i.e. it must be used for tuition

-- Not sure I understand the question... It is athletic scholarship so I guess it must be used for tuition, room and board etc.

Box 1 of the 1099-Q

-- $20,000

Box 2 of the 1098-Q

-- $6,116 (I assume you meant 1099-Q)

Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)?

-- Parent (myself)

Room & board paid. If student lives off campus, what is school's R&B charge. If the student lives at home, only the school's board charge for on campus students. 

-- Student lives on campus, fully paid by the scholarship.

Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers

-- No

How much taxable income does the student have, from what sources

-- None

Are you trying to claim the tuition credit (are you eligible)?

-- If I understand correctly, my income is too high for claiming tuition credit.  

Is the student an undergrad or grad student?

-- Undergrad, 18 yo, freshman year, just started college last fall.

[Hal_Al · Accepted solution]

Re the 1098-T: earlier you said box 1 was $27,000 and box 5 $19,000.   Now it's reversed, Box 1 ($18,812)  and box 5  ($27,316), which makes more sense, so I assume that's right

Enter the 1099-Q before you enter the 1098-T.

For purposes of calculation, I assume her room and board is 27,316 - 18,812 = $8504.  That, by the way, is the taxable portion of her scholarship and is not enough for her to have to file (less than $12,550).   

At educational expenses (yes, you enter her 1098-T on your return), enter the 1098-T  and $8504 room and board.  To get the screen to enter Room & Board, answer yes when asked if you have book expenses. When asked how much of the scholarship was used for room and board, enter $8504 again. You will eventually reach a screen "amount used to claim the education credit".   TT may have  prepopulated that with $4000 (or $10,000), you should change it to 0, since you cannot claim the tuition credit.  If don't get that screen, verify on the student information work sheet (part VI, line 17) that 0 (or blank) was used for the credit. 

That's all you need to do.  TT will calculate the taxable portion* of the 529 earnings and generate form 5329 for the penalty exception.  

*You have $27,316 of qualified expenses. $18,812 were used to keep some of  the scholarship tax free. That leaves $8504 that can be used for the 1099-Q.  8504 / 20,000 = 42. 52% of the earnings are tax free (57.48% are taxable). You have 0.5748 x 6116 =$3515 taxable income.

We can reduce that, assuming the scholarship is not restricted. She can declare as much as $12,550 of the scholarship to be taxable and still not owe any tax (or have to file a return).  12,550 / 20,000 = 62.75% tax free earnings (37.25% taxable).  0.3725 x 6116 = $2278.  In TT enter 12,550 when asked how much of the scholarship was used for room and board. Note the wording at that screen “or other expenses”. You didn’t have to literally use the scholarship for R&B. 

Details will be shown on the Student Information worksheet and the 1099-Q worksheet.

[circle11]

Sorry - my bad re: mixing up box 1 and box 5 on 1098-T earlier. Yes the latter is correct. Will play more with these numbers tomorrow and get back to you. Thanks again!

[circle11]

I think I get it now - thank you so SO MUCH!

Last question: changing R&B and other expenses to $12,550 saves me around $500. Does this entail any risks or is this more or less common wisdom and frequently done that way? 

[JulieS]

The only risk involved is if you get audited and you can't provide proof of having paid that amount in room, board and other expenses. 

This strategy is used frequently and doesn't raise your risks more than others claiming this credit.