529 plan scholarship refunded late

[soccerdad1]

My son received a scholarship which was paid to the university in 2021.  He graduated in 2021 and had excess left over in his 529 plan.  We requested a distribution from the 529 plan at the end of 2021 that matched the value of the scholarship.  He received the distribution but it was dated Jan 3, 2022, even though it was requested in 2021.  Therefore he did not receive a 1099Q for this money for 2021.  I am sure he will get the 1099Q next year.  The scholarship is listed on the 2021 1098T.  Can he include the money this year on his taxes?  We are concerned that if he waits to include it on his 2022 taxes, it will be non qualified and he will incur a penalty.  Also his tax bracket will be higher for 2022.  

[Hal_Al]

You're not gonna get a clear cut answer, other than you shoulda done a better job on your timing.

The rules say is that the distribution must be in the same year that the expenses were paid to be a qualified distribution.  Pub 970 is not that clear on whether the years must be matched, if you are only claiming the scholarship penalty exception. 

I would claim the distribution on my 2021 tax return.  TurboTax (TT) will calculate the taxable amount and prepare form 5329 to claim the penalty exception (because of the scholarship).  We have not seen any reports of how the IRS will treat this situation in case of an audit.  But, this is the advice usually given. Be prepared to explain it if you get an inquiry.  We have noted, in this forum, a significant drop in IRS letters on 1099-Qs, as the IRS recognizes that they are always covered and well documented. 

Be advised the TT interview is tricky.  You need to have a sense of what the output should be. 

Ignore the 2022 1099-Q, since it will have been reported on the 2021 return.  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." 

[soccerdad1]

Thanks so much for the quick answer.  I know we should have requested it earlier.  I somehow thought it would be automated and would post in a couple days.  Dumb me.  We spent too much time determining if we should only request the 2021 scholarship reimbursement, or the amount of the entire scholarship that he received over three years.  We took the conservative approach but I still feel it is crazy that you can't wait until the last year and take all the scholarship money since you won't know if you are hurting yourself until the student is done with school.  The last thing we wanted him to do was run out of 529 money before he was done.  Anyway, thanks and I will remember this when my girl is finishing her degrees.

[GeorgeM777]

To follow-up on the comments from @Hal_Al, there is no definitive guidance on the issue you raise.  There was some attempt to get clarity on the issue in 2008 when the Treasury Department issued the following proposed IRS Guidance:

"Section 529 is silent regarding whether distributions must be made from a section 529 account in the same tax year as QHEEs were paid or incurred. Concerns have been raised that individuals could allow the account to grow indefinitely on a tax-deferred basis before requesting reimbursement or use distributions in earlier years to pay QHEEs in later years. Accordingly, the IRS and the Treasury Department propose to adopt a rule that, in order for earnings to be excluded from income, any distribution from a section 529 account during a calendar year must be used to pay QHEEs during the same calendar year or by March 31 of the following year. The IRS and the Treasury Department welcome comments on rules necessary to ensure that distributions from section 529 accounts are appropriately matched to the payment of QHEEs."

However, the idea to add clarification to this situation never became a reality.  IRS Publication 970 which explains many matters of 529 tax law, makes no mention of reimbursement withdrawal deadlines.  Neither does IRS Topic No. 313, which explains Qualified Tuition Programs such as 529 plans. 

Consequently, some tax professionals recommend that the reimbursement for qualified expenses be effected in the same year that the expense occurred.  If this cannot be done, then perhaps reimbursing prior to March 31 of the next year may provide some back-up.  The point to remember is that there still remains no specific IRS guidance on the issue you have raised.

@soccerdad1

[Hal_Al]

This article also seems to support the argument that you're OK being late, for the scholarship penalty exception.

https://www.investopedia.com/news/penaltyfree-way-get-529-money-back/

I edited my reply, above, for this, and GeorgeM777's reply. 

[soccerdad1]

OK,

I think he will proceed and use this on his 2021 return.  Since he does not have a 1099Q for it, where does he input the income?  

Thanks so much for all the help!

[Hal_Al]

You still input it at the 1099-Q screen.  And you input the off setting expenses and scholarship at the 1098-T screen.