Taxable 529 Distribution, Student's Taxes

[sgt-loudmouth]

How does the student account for a taxable 529 distribution on his/her tax return, when the parent enters the 1099-Q and 1098-T into TurboTax?

Each year, my student receives a scholarship for about $10,000. This year, we will withdraw a taxable $10,000 from the 529 plan to pay for other expenses. The $10K is offset by the scholarship, so its earnings will be taxable but not penalized.

I'm the parent and the trustee on the 529. I pay the college bills. Each semester, we have a 529 check sent to the student to cover the expenses, which he signs over to me, thus ensuring the 1099-Q names him. I enter the 1098-T and the 1099-Q in TurboTax, and TT calculates the taxes.  My student has never filed a tax return.

I plan to file my TTax as I always have, entering both the 1099-Q and the 1098-T. I know from experience, TTax will alert me that the earnings on the $10K are taxable to the student.  I think I'm clear about how *I* file this.

How does the *student* file this?  Does he re-enter the 1099-Q and the 1098-T. That sounds bad.  Somehow he's got to break out the principal and the earnings, since only the earnings are taxable.

[Hal_Al · Accepted solution]

Q. How does the student account for a taxable 529 distribution on his/her tax return, when the parent enters the 1099-Q and 1098-T into TurboTax?

A. The parent does NOT enter the 1099-Q on their return.

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 can (and usually should) go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

Q. How does the *student* file this?  Does he re-enter the 1099-Q and the 1098-T?

A.  Yes, the student enters the 1099-Q and any expenses not claimed by the parent.  That may or may not  require the student to also enter the 1098-T to show he had expenses that were covered by scholarship.   There is a place to enter any tuition used (claimed) by the parent, for the tuition credit, so that it is backed out of the calculation. 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 (on the parent's return)

 =$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

The student has $1120 of taxable income. But there will be no penalty because the other $2000, of the distribution, was covered by scholarship and/or the tuition credit. 

**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. 

[sgt-loudmouth]

Thank you for that helpful reply.  To make sure I understand, here's my take-away:

• When one enters a 1099-Q into TurboTax, marked as a dependent's 1099-Q, TT uses it to help generate the Student Information Worksheet, but does not attach it to the return.
• I should enter the 1099-Q on the student's return.  (It is harmless to enter it in my TT, marked as the dependent's.)
• For each education expense:
  • If it was paid by the 529 plan, we'll enter that expense on his return, to balance the 1099-Q.
  • If I paid it, it can go on my return for the AOTC. It will also go on his return, and will be backed out by the "place to enter any tuition used (claimed) by the parent."
  • The back-out item on his return is how double-dipping is avoided.
• The taxable distribution from the 529 shows up on his return due to the 1099-Q, and should be entered in the space for withdrawals not subject to 10% penalty (because it matches up with a scholarship), and the *earnings* portion will be taxed at the appropriate rate.
• Since he's a dependent student under 25, *earnings* over $2200 will be taxed at my rate, due to the kiddie tax.

All 529 distributions have been payable to the student or to the school.

Is that a fair take-away?

[Hal_Al]

Yes, you generally have it correct.  But, not exactly.

Do not enter the 1099-Q on your return. It is not harmless. 

The kiddie tax applies to full time student under 24 (not 25), whether a dependent or not.

TurboTax (TT) can handle it, but it can get tricky.  Although there is space for withdrawals not subject to 10% penalty on the worksheets, you will not see that question in the interview. The calculation is "behind the scenes".  TT will generate IRS form 5329 to claim the penalty exception.

Be advised some people are saying they're not getting the "Amount used to claim the tuition deduction or credit" screen in the student's interview . The alternate workaround is  to enter $4000 less than the actual box 1  amount, when you enter the 1098-T on the student return (assuming you used $4000 [the normal amount to claim the maximum AOTC] on your return)

[sgt-loudmouth]

Checking one more piece...

My student isn't otherwise required to file a tax return. I should go through the motions of entering his tax return (including the 1099-Q and the expenses), to be sure he doesn't have a liability for over-withdrawing from the 529.   If I kept the 529 disbursements low enough that he has no "unearned income" to declare from the 529, he needn't file a return with the IRS.  Right?  

[Hal_Al]

Q. My student isn't otherwise required to file a tax return. If I kept the 529 disbursements low enough that he has no "unearned income" to declare from the 529, he needn't file a return with the IRS.  Right?  

A.  Yes.  The filing threshold for a full time student-dependent, is $1100 of unearned income.  

But, there's a better way.  Scholarship income is also unearned income.  But, scholarship income is treated as earned income, for the purpose of calculating a dependent's standard deduction.  So, if the student declares his $10,000 scholarship as taxable income, he can then claim the education  expenses, not used by the parent for the tuition credit,  as covered by the 529 plan distribution and none of the distribution is taxable.  It's a perfectly legal loop hole, unless the conditions of the scholarship are that it be used to pay for qualified expenses.  A dependent's standard deduction is limited to $1100 or his earned income + $350 (but not more than $12,400). 

Technically, the student still doesn't need to file a tax return  Bit you may want to have him file to document the reporting of the scholarship as income. 

[anonymouse1]

1.  Does TT (Basic, or do we need to buy a higher level product) link the parents' and dependent student's returns?

2.  Do taxable scholarships count as earned income for the purpose of figuring allowable IRA contributions for the student?  E.g., if student earned $2000 from a part time job, and had $4000 in scholarships claimed as income, could the student put $6000 in a Roth IRA for that year, or only $2000?

[Hal_Al]

There is no "linking" of parent  and student-dependent returns, in any version of TT.  Any info needed (from the other return) has to be manually entered.

Taxable scholarships only counts as earned income (compensation"), for the purpose of figuring allowable IRA contributions, if the student is a grad student.

If an undergrad earned $2000 from a part time job, and had $4000 in scholarships claimed as income, the undergrad could only put $2000 in an IRA.  A grad student could put $6000. 

[mndavec]

I've noticed there is a BUG in turbotax if you check that your student attended BOTH High School and College in the same year (typical for a College Freshman) that it mistakenly calculated the max exempt withdrawal as $10,000. I had to uncheck "High School" on the Student Information form to work around this. Seems like no way to contact TurboTax to report this BUG in their logic.