TT won't use education expenses to offset 529 plan withdrawals

[Feldgrep]

I'm filling out my son's tax return. He's a senior in college, still a dependent on my return, but he's got some earned income from a summer job, and a relatively small amount of dividend and capital gains income from an E-Trade account. His income is such that he gets a refund of all withheld taxes from his summer job, and no taxes owed on his investment income. So far, so good.

But...he's got a 1099-Q showing $37,000 in distributions from his 529 account, as well as a 1098-T from his college showing $25,000 in scholarship money and $45,000 in tuition payments. So, $45K in tuition minus $25K in scholarships leaves $20K in tuition. That $20K plus $15K for room and board plus another $2K for books and supplies adds up to $37K which should completely offset the 529 distributions.  However, when I enter all the expenses, TT tells me he's not eligible for an education deduction or credit because either a) I can claim him as a dependent on my return, OR b) distributions exceed the education expenses (which they don't), OR c) there were no net qualified education expenses (which there were). I've started and re-started his return multiple times, and worked carefully through each Easy Step section, and always wind up owing taxes on that $37K in 529 distributions. What gives?

[SusanY1 · Accepted solution]

Since he is a dependent on your return, the education expenses and deductions from the 1098-T would normally be on your return (for the education credit), but it appears here that the expenses were covered by the 529 plan distribution so there is no credit, so there is no need to enter the form, and his scholarships are less than tuition so there is no taxable scholarship income for him to report here, so you can delete this form from TurboTax.  

Since the Form 1009Q distribution was completely offset by qualified expenses, it is not required to be listed on either your tax return or his - the IRS only requires that it be entered on a taxpayer's return when there is a taxable distribution.  There does not appear to be a taxable distribution in his case.  Also, delete this form. 

Keep both forms and your receipts along with the tax returns (yours and his) in an easy to locate file for three years on the off-chance that either of you are later asked to support the expenses (this is uncommon, but it does occasionally happen.) Should the IRS send a letter addressed to either of you asking for support for the expenses to match the 529 distribution, you will be able to make quick copies and forward them along. 

[NCperson]

i agree with @SusanY1 explanation with one exception; there was no discussion of AOTC.  are you eligible? (joint income under $160,000).   If you are not eligible, then I agree with @SusanY1 comments.  Otherwise, here is how it should work.

1) 1098-T goes on YOUR tax return (I assume your child is your dependent)

2) There are $20,000 of net expenses on the 1098-T. (Box 1 less Box 5) 

3) you should get $2500 of AOTC credits which consumes  $4000 of the expenses (IRS math) But look at form 8863 for the exact amount. $4000 is the maximum.

4) that leaves $16,000 of expenses and let's add in the $15,000 for room and board and $2000 of books or $33,000

5) Assuming your child's social security number is on the 1099Q, there was a $37000 distribution from the 529 but only $33,000 of expenses remaining ("the double dip rules").  Therefore $4,000 didn't need to be distributed so $4000/ $37000 or 10.8% of the BOX 2 earnings on the 1099Q is taxable EARNED income to YOUR CHILD (not you!).  And if he has no federal withholdings and his Earned Income is lower than lesser of total Income + $350 OR $12,000, then there is no need to file as there are no taxes to be paid. 

make sense? it's not easy! 

[SusanY1]

Great catch on the AOTC -- yes, this should definitely go on your return if you are eligible for this credit.

If this applies to you, please print out this wonderful illustration that  @NCperson has shared and add it to your file so that you'll remember this next year, too!  

Trying to combine these various education benefits gets fairly complicated and this is a fantastic breakdown of how it works when you are eligible for the American Opportunity Credit.  

Thank you, @NCperson!!    

[Carl]

I'm filling out my son's tax return. He's a senior in college, still a dependent on my return, but he's got some earned income from a summer job, and a relatively small amount of dividend and capital gains income from an E-Trade account.

Bottom line is, your son will file his own tax return to report that income.No exception here.

His income is such that he gets a refund of all withheld taxes from his summer job, and no taxes owed on his investment income. So far, so good.

Yep. Now comes the "but". 🙂

But...he's got a 1099-Q showing $37,000 in distributions from his 529 account, as well as a 1098-T from his college showing $25,000 in scholarship money and $45,000 in tuition payments.

Bottom line with no exception here. If the 1099-Q has the student's SSN in the recipient's box, then *IF* the 1099-Q is required to be reported, (I stress *IF*) the student has no choice and must report that 1099-Q on the student's tax return.

So, $45K in tuition minus $25K in scholarships leaves $20K in tuition.

I'm with you so far.

That $20K plus $15K for room and board plus another $2K for books and supplies adds up to $37K which should completely offset the 529 distributions.

So the reality is, there is a total of $62,000 of "third party income" received from other sources. $37K in 529 distributions added to $25K of scholarships gives a total of $62,000 of "third party support" provided to the student. Keep this number in mind.

The student has $37K in qualified education expenses (tuition, books and lab fees) and another $15K for the unqualified but allowed expense of room and board that was paid "in direct support" of the education. That gives a total of $52,000 in deductible expenses for education.

Since $62,000 in third party support was received in 2019 and only a total of $52,000 of that was used to pay for qualified education expenses and "allowed" expenses, that means there's $10,000 of taxable income remaining.

Therefore, while you will still claim the student as your dependent, it is the student who will report "ALL" of the education stuff on their tax return. It is the student that will pay taxes on the excess $10K of third party support. Additionally, the student will be taxed at the higher, parents' tax rate on that $10K only.

TT tells me he's not eligible for an education deduction or credit because either a) I can claim him as a dependent on my return,

..and that is a true statement.

b) distributions exceed the education expenses (which they don't),

Unless I missed something, using your numbers the third party support received by the student, exceeds the total of all the qualified education expenses and the allowed education expenses of room and board.

c) there were no net qualified education expenses (which there were).

I don't see any qualified out of pocket expenses at all here. Remember, out of pocket money can not be used for room and board. Neither can scholarships. Only 529 funds can be used tax free for room and board.

Here's the scenario of how the IRS prioritizes and applies this stuff.

--------------------------------------------------------------

First, scholarships & grants are applied to qualified education expenses. The only qualified expenses for scholarships and grants are tuition, books, and lab fees. that's it. If there is any excess, then it's taxable income to the student. It automatically gets transferred to and included in the total on line 7 of the student's 1040.

Next, 529/Coverdell funds reported on 1099-Q are applied to qualified education expenses. The qualified expenses for 1099-Q funds are tuition, books, lab fees, AND room & board. That's it. If there are any excess 1099-Q funds they are taxable. The amount is included in the total on line 7 of the student's tax return..

Finally, out of pocket money is applied to qualified education expenses. Out of pocket expenses can only be used for tuition, books, and lab fees. That's it. Out of pocket expenses can not be used for room and board.

When you have a 1099-Q it is extremely important that you work through the education section of the program in the order it is designed and intended to be used. If you do not, then there is a high probability that you will not be asked for room & board expenses, and you could therefore be TAXED on your 1099-Q funds.

Finally, if "all" qualified expenses are covered by scholarships, grants, 1099-Q funds and there is ANY of those funds left over, the left over excess is taxable. While the parent can still claim the student as a dependent, it is the student who will report all the education stuff on the student's tax return. That's because the STUDENT pays the taxes on any excess scholarships, grants and 1099-Q funds.

[Carl]

I'm filling out my son's tax return. He's a senior in college, still a dependent on my return, but he's got some earned income from a summer job, and a relatively small amount of dividend and capital gains income from an E-Trade account.

Bottom line is, your son will file his own tax return to report that income.No exception here.

His income is such that he gets a refund of all withheld taxes from his summer job, and no taxes owed on his investment income. So far, so good.

Yep. Now comes the "but". 🙂

But...he's got a 1099-Q showing $37,000 in distributions from his 529 account, as well as a 1098-T from his college showing $25,000 in scholarship money and $45,000 in tuition payments.

Bottom line with no exception here. If the 1099-Q has the student's SSN in the recipient's box, then *IF* the 1099-Q is required to be reported, (I stress *IF*) the student has no choice and must report that 1099-Q on the student's tax return.

So, $45K in tuition minus $25K in scholarships leaves $20K in tuition.

I'm with you so far.

That $20K plus $15K for room and board plus another $2K for books and supplies adds up to $37K which should completely offset the 529 distributions.

So the reality is, there is a total of $62,000 of "third party income" received from other sources. $37K in 529 distributions added to $25K of scholarships gives a total of $62,000 of "third party support" provided to the student. Keep this number in mind.

The student has $37K in qualified education expenses (tuition, books and lab fees) and another $15K for the unqualified but allowed expense of room and board that was paid "in direct support" of the education. That gives a total of $52,000 in deductible expenses for education.

Since $62,000 in third party support was received in 2019 and only a total of $52,000 of that was used to pay for qualified education expenses and "allowed" expenses, that means there's $10,000 of taxable income remaining.

Therefore, while you will still claim the student as your dependent, it is the student who will report "ALL" of the education stuff on their tax return. It is the student that will pay taxes on the excess $10K of third party support. Additionally, the student will be taxed at the higher, parents' tax rate on that $10K only.

TT tells me he's not eligible for an education deduction or credit because either a) I can claim him as a dependent on my return,

..and that is a true statement.

b) distributions exceed the education expenses (which they don't),

Unless I missed something, using your numbers the third party support received by the student, exceeds the total of all the qualified education expenses and the allowed education expenses of room and board.

c) there were no net qualified education expenses (which there were).

I don't see any qualified out of pocket expenses at all here. Remember, out of pocket money can not be used for room and board. Neither can scholarships. Only 529 funds can be used tax free for room and board.

Here's the scenario of how the IRS prioritizes and applies this stuff.

--------------------------------------------------------------

First, scholarships & grants are applied to qualified education expenses. The only qualified expenses for scholarships and grants are tuition, books, and lab fees. that's it. If there is any excess, then it's taxable income to the student. It automatically gets transferred to and included in the total on line 7 of the student's 1040.

Next, 529/Coverdell funds reported on 1099-Q are applied to qualified education expenses. The qualified expenses for 1099-Q funds are tuition, books, lab fees, AND room & board. That's it. If there are any excess 1099-Q funds they are taxable. The amount is included in the total on line 7 of the student's tax return..

Finally, out of pocket money is applied to qualified education expenses. Out of pocket expenses can only be used for tuition, books, and lab fees. That's it. Out of pocket expenses can not be used for room and board.

When you have a 1099-Q it is extremely important that you work through the education section of the program in the order it is designed and intended to be used. If you do not, then there is a high probability that you will not be asked for room & board expenses, and you could therefore be TAXED on your 1099-Q funds.

Finally, if "all" qualified expenses are covered by scholarships, grants, 1099-Q funds and there is ANY of those funds left over, the left over excess is taxable. While the parent can still claim the student as a dependent, it is the student who will report all the education stuff on the student's tax return. That's because the STUDENT pays the taxes on any excess scholarships, grants and 1099-Q funds.

[NCperson]

@Carl - sorry but the math isn't making sense

if I think about this as 'sources and uses"

1) there were $62k of sources - the $37k from the 529 distribution and $25k from the scholarships

2) there were $62k of uses - $45k for tuition, $15k for room and board and $2k for books

the net is zero and there is no need to report the 1099Q.  

same situation, but now AOTC is included:

1) there were $66k of sources - the $37k from the 529 distribution and $25k from the scholarships and $4000 for AOTC (which yields the $2500 credit)

2) there were $62k of uses - $45k for tuition, $15k for room and board and $2k for books

3) therefore $4000 of the 529 distribution was not required meaning that $4k/$37k or 10.8% of 1099Q / Box 2 is taxable.  I'd certainly pay tax on the 10.8% to get the $2500 credit!!!!!

if I look closely at your math it appears the scholarship was used twice.  first, it was netted against the $45,000 of tuition (to yield the $20,000) and then later it was declared a 'source' as part of the $62,000 when it was already netted out of the figures to compare to the $52,000- hence it was used twice.  also, the student did not have $37,000 of qualified expenses - it was $62,000 (tuition = $37000, room and board = $15000 and books = $2000); that $37,000 off the 529 is a 'source' and not a 'use'.   If I remove the extra $25,000 from the duplicate scholarship "source" and reflect the additional $15,000 of qualified expenses which is a use that brings the income of $10,000 you originally presented back to zero. 

hope this brings some clarity to the subject.....

[Carl]

1) there were $62k of sources - the $37k from the 529 distribution and $25k from the scholarships

The $25K gets applied first, and it can not be applied to room and board. It can only be applied to the 47K of qualified expenses. That leaves $22K left.

$22K of the 529 is applied to the remaining qualified expenses, meaning that nobody qualifies for any tax credits or deductions at all. Not a penny. But there's still $15K left over from that 529 distribution which is applied to the room and board. There's nothing left over that's taxable (don't know why I came up with $10K taxable before) but the point is, nobody qualifies for any education credits or deductions of any kind. Not a penny.

[NCperson]

@Carl - agreed as long as the taxpayer is not eligible for AOTC..... but if they are eligible for AOTC....

The $25K gets applied first, and it can not be applied to room and board. It can only be applied to the 47K of qualified expenses. That leaves $22K left. AGREED (your $47k is the $45k of tuition and $2k of books)

of that $22k that is left it can be used for AOTC and the max is $4,000, leaving $18,000

now we add back in the Room and Board of $15,000, giving us $33,000 of remaining expenses

the 529 distribution was $37,000, meaning $4,000 of Box 1 was unnecessary so that $4k/$37k or 10.8% of Box 2 is taxable earnings.

the "cost" of obtaining the $2500 AOTC credit is that some of the Box 2 earnings are taxable and that is a good trade! 

[Carl]

the "cost" of obtaining the $2500 AOTC credit is that some of the Box 2 earnings are taxable and that is a good trade!

Since the student has to report the 1099-Q distribution on their own tax return, that student can claim that $15K of it was used to pay for room and board. But since the parents are claiming the education stuff, wouldn't that mean the left over amount from the 1099-Q (22K) would be taxable income to the student?

How can the student claim any amount of that money was spent on qualified expenses, when the parents are already claiming those qualified expenses? Keep in mind also, that any excess is taxed to the student, at the parents' higher tax rate too.

[NCperson]

see IRS  publication 970 page 60

Coordination With Tuition and Fees Deduction A tuition and fees deduction (see chapter 6) can be
claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses aren't used for both benefits.

it never says you can't transfer unused dollars from parent to student (and let's assume the student has to be a dependent of the parent)

[Feldgrep]

We are NOT eligible for the AOTC. Since the 529 disbursements are paid to our son, as the beneficiary, rather than myself, as the account holder, it seemed to make logical sense to include the disbursements, and therefore the offsetting expenses including the tuition payments from the 1098-T, on his return. TurboTax EasyStep seemed to be fine with this approach, up until the point where I entered the last of his offsetting expenses, at which point the program insisted that he couldn't claim a CREDIT (which I wasn't trying to claim) because he was a dependent on my return, and his 529 distributions were therefore taxable income for him.

[smithmandi]

But what if the educational expenses do not fully offset the distribution, so a portion -- but not all -- of the distribution IS taxable? When I input the 1099Q, TT taxes it all and there appears to be no option to input the amount that went to legitimate educational expenses (above and beyond what the college reported on the 1098, which appears relevant only to the tax credits). How do I make sure only the portion of earnings that wasn't attributable to education expenses (QHEE/distribution * earnings subtracted from earnings) is factored into TT's system???

[trienzo]

If I can follow the conversation, is your recommendation to answer "No" to the question "Did you receive a Form 1099-Q even if we received one? 

[DavidS127]

Note that when you have a 1099-Q (529 plan) distribution and someone on your tax return is also eligible for other education credits (such as the American Opportunity Credit or AOTC) there is a screen in TurboTax where you are asked to "allocate" education expenses to those credits versus the 529 plan distribution.  Generally, it is best to allocate enough (but only enough) to these credits first, with the remaining education expenses applied against the 529 plan distribution.

That allocation between education credits and 529 plan distributions can also be done in the Forms mode of your Download/CD version. Go to Forms mode and find the applicable "Student Info Wk".  Scroll down to Part VI and find line 17.  If you enter $4,000 on line 17, TurboTax will first use $4,000 of your qualified expenses for the education credits/deductions (e.g., AOTC) and then use the rest of the expenses you entered to apply against the 1099-Q (529 plan) distribution.  If you enter zero, all the expenses will be allocated to the 529 plan distribution.

@smithmandi

@trienzo

[trienzo]

Why doesn't Turbo Tax take me to this worksheet even if I don't qualify for any education credits.  It seems I need to use it to allocate educational expenses to justify my 529 distributions.