Treatment of Taxable 529 Plan

[Luna_Tax]

Hello everyone,

Our Son received a full scholarship in 2024 which paid for everything including his room and board.  Since his entire college bill was covered by his scholarships; our state 529 plan would not make a payment to his school directly as they had done in the past.  Instead, they sent the reimbursement check to me (the parent) and the Form 1099-Q was also issued to my social security number.  Under my Son’s Turbo Tax (“TT”), I chose that he did NOT receive any Form 1099-Q (since 1099-Q was issued to me).  Under the parents’ TT, I chose that I was the recipient of Form 1099-Q and the 529 plan distributions were used to pay for the education expenses of my student.  Also, under our TT’s education expense input forms, I entered that $20k of the scholarship funds were used to pay for room and board.

My questions are as follows: 1-Is it correct to answer in TT that the 529 plan distributions were used to pay for the education expenses of the student even though the distribution was sent to parents directly instead of the college?

2-Our 1040 does NOT show the earnings per Box 2 of Form 1099-Q, as “Other Income” on Sch 1, line 8z, even though we received the Form 1099-Q.  Is that a correct treatment?  Is it because the earnings from the 529 plan were applied towards the room and board expenses thus making the earnings tax-free and therefore, not required to be shown as “Other Income”?

Thank you in advance for your time and expertise.

[Hal_Al · Accepted solution]

Q1-Is it correct to answer in TT that the 529 plan distributions were used to pay for the education expenses of the student even though the distribution was sent to parents directly instead of the college?

A1. No.  It's irrelevant who the distribution was sent to. You can say the distribution went to room and board, even though the scholarship paid for R&B. This is because R&B is not a qualified expense for tax free scholarship but is qualified for a 529 distribution. 

Q2-Our 1040 does NOT show the earnings per Box 2 of Form 1099-Q, as “Other Income” on Sch 1, line 8z, even though we received the Form 1099-Q.  Is that a correct treatment? 

A2. Yes, depending on the amounts. 

Q3. Is it because the distribution (not earnings) from the 529 plan were applied towards the room and board expenses thus making the earnings tax-free and therefore, not required to be shown as “Other Income”?

A3. Yes. But the part of  the scholarship that went to R&B will be taxable on the student's tax return (it's taxable even if you didn't take a 529 distribution).

There are some options available to you, maybe even claiming the education credit.  

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 1099-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 on campus charge. If he lives at home, the school’s R&B “allowance for cost of attendance” for student living with parents.
• 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, income not too high)?
• Is the student an undergrad or grad student?
• Is the student a degree candidate attending school half time or more?

____________________________________________________________________________________________

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 American Opportunity Credit (AOC or AOTC) is 100% of the first $2000 of tuition and 25% of the next $2000 ($2500 maximum credit). 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 regardless of whose money was used to pay 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 which is only qualified for the 1099-Q)

   -$3000 paid by tax free scholarship***

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q (on the recipient’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

There is  $1120 of taxable income (on the recipient’s return)

**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. A student, with no other income, can have up to $14,600 of taxable scholarship (in 2024) and still pay no income tax. 

[Luna_Tax]

Thank you so much for your comprehensive response. I really appreciate you taking the time to explain. I don’t think we are able to take the AOTC in 2024 due to the fact that he had a taxable scholarship of about $29k. I have filled out the info, please see below.

I also have a related question.  We have claimed our Son (under 24 and a full-time student) as our dependent in our 2024 return.  He received a full scholarship in 2024 that paid for his tuition, fees, room and board, etc.  According to IRS, a taxpayer needs to provide more than half of living expenses/financial support of a qualifying child in order to claim them as a dependent.  My understanding is that taxable scholarships are “unearned income” and as such they do NOT count when determining if your qualifying child can financially support themselves.  As such, is it correct that we claimed him as our dependent on our return and he stated on his return that he is a dependent of someone else?

Information:

• Are you the student or parent.  Parent
• Is the  student  the parent's dependent.  Yes
• Box 1 of the 1098-T -$60k
• box 5 of the 1098-T - $90k
• Any other scholarships not shown in box 5 - No
• Does box 5 include any of the 529/ESA plan payments (it should not) – No, 529 was paid to me (parent) directly in 2024
• Is any of the Scholarship restricted; i.e. it must be used for tuition – No. The college received various scholarships (merit/finaid/grants) and charged various expenses (tuition, room and board, fees, insurance, etc.) against them.  I don’t believe there are any restrictions.
• Box 1 of the 1099-Q - $2,400
• Box 2 of the 1099-Q - $700
• Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)? - Parent
• Room & board paid. $20k (NOT in box 1 of Form 1098-T)
• Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers - $1k (I have already accounted for this in the $29k above)
• How much taxable income does the student have, from what sources – W-2: $6k; 1099misc: $10k (internship) and his taxable scholarship
• Are you trying to claim the tuition credit (are you eligible, income not too high)? Income wise we are not high, but TT says we are not eligible for the credit due to his taxable scholarship.  We had partial AOTC in the last couple of years since he had smaller scholarships which were not taxable.  However, in 2024 some of his scholarships are taxable.
• Is the student an undergrad or grad student? Undergrad
• Is the student a degree candidate attending school half time or more? Yes

[Hal_Al · Accepted solution]

Q.  Is it correct that we claimed him as our dependent on our return and he stated on his return that he is a dependent of someone else?

A. Yes. 

Q. According to IRS, a taxpayer needs to provide more than half of living expenses/financial support of a qualifying child in order to claim them as a dependent.  

A. No. There are two types of dependents, "Qualifying Children"(QC) and Other ("Qualifying Relative" in IRS parlance even though they don't have to actually be related). There is no income limit for a QC but there is an age limit, student status, a relationship test and residence test. The support test, for a QC, is only that the child didn't provide more than half his own support. The support test for a Qualifying Relative is that the taxpayer provided more than half the relative's support.

Q.  My understanding is that taxable scholarships are “unearned income” and as such they do NOT count when determining if your qualifying child can financially support themselves. 

A.  Not exactly. Scholarships are simply ignored in the support calculation. *

You can completely ignore the 1099-Q.  Do not enter it. Room & Board more than covers it. 

You can claim the full AOTC on your return.  For simplicity, enter the 1098-T with $4000 in box 1 and box 5 blank.

On his return, he enters the 1098-T with 0 in box 1 and $33,000 in box 5 ($29,000 + 4000).  He will pay $480-$880 more tax on the additional $4K, depending on YOUR tax bracket (the kiddie tax applies on this much scholarship income).  But, you will get the full $2500 AOC (depending on your tax liability). 

"We had partial AOTC in the last couple of years since he had smaller scholarships which were not taxable."

If your AOTC was less than $2500, you should look at filing amended returns.  Depending on how much taxable scholarship he had, maybe only if less than $2000.  The AOC is 100% of the 1st $2000 and 25% of the next $2000.  His additional reportable scholarship will actually not get taxed if his total income is less than $14,600. 

*Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024) and the dependent standard deduction calculation (earned income + $450).  It is not earned income for the kiddie tax and other purposes (e.g. EIC).  For grad students and post grad fellows (but not undergrads), scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.

Taxable scholarship goes on line 8r of Schedule 1, from which TT treats it as hybrid income.

[Hal_Al · Accepted solution]

There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. 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 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.

Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket. She would only need to report $5000 of taxable scholarship income, instead of $6000.

The IRS actually encourages use of this technique. From the form 1040 instructions: “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040 and IRS.gov/EdCredit".  PUB 970 even has examples of how to do the “loop hole”.

[Luna_Tax]

Thank you again for all your patience and guidance.  I really appreciate you taking the time to explain the tax rules, exceptions and nuisances to us even though I am sure you have explained them at least 500 times before!

I adjusted our input for both returns as you had explained.  I have some additional questions:

1-You mentioned above, “You can claim the full AOTC on your return.  For simplicity, enter the 1098-T with $4000 in box 1 and box 5 blank.” I made these changes in our TT but I didn’t change any of the other input screens that followed meaning I still have that $1k was paid for textbooks and $20k was paid for the room and board.  Is this correct?

2-Line 17 Used for Credit on our Qualified Elementary and Secondary Tuition smart worksheet shows 0.  Is this correct?  Shouldn’t this be $4k, considering I entered $4k in eligible expenses in Box 1 of Form 1098T?  I also manually changed this number to $4k to see if anything changes and our tax refund did NOT change.  What is the purpose of this number anyways?

3-You mentioned above, “On his return, he enters the 1098-T with 0 in box 1 and $33,000 in box 5 ($29,000 + 4000).”  I made these changes in my Son’s TT.  Should I use $34k in Box 5 instead of $33k?  The $34K is made up of $30k taxable scholarship (Form 1098T) plus the $4k.  The $29k in my example above was already reduced by the $1k for textbooks and eligible fees.  As I mentioned above, I am still including the $1k for books and fees in the input screens for both us and my Son. I want to make sure that I am NOT double-dipping for the $1k for the textbooks since it is in two places.

4-Line 17 Used for Credit on my Son’s Qualified Elementary and Secondary Tuition smart worksheet, is blank (doesn’t even show a 0).  Is this correct?  The first time I had entered the 1098T information for him a few weeks ago, I had seen an input screen for “Education Expenses Used for a Tax Credit” which said “…if the person who claimed you as a dependent also claimed AOTC for these expenses, then you need to enter $4,000 in the box below in order to calculate education credit.”  However, this screen doesn’t show up in his TT, so I cannot enter the $4k in the box. I hope TT is calculating it correctly.

5-Do we need to attach a statement to our tax returns (at least my Son’s return), to clarify why there is additional scholarship income on his Sch 1 that is in excess of what is shown on Form 1098T?

[Hal_Al]

Q1. I made these changes in our TT but I didn’t change any of the other input screens that followed meaning I still have that $1k was paid for textbooks and $20k was paid for the room and board.  Is this correct?

A1. No. You should have entered no other numbers. Although on your tax return, it will make no difference.  You still get the $2500 credit.

Q2. Line 17 Used for Credit on our  worksheet shows 0.  Is this correct?  

A2. I don't think it matters when using the short cut, as long as you are getting the $2500 credit.  You talk about "your refund not changing". Verify that you're getting $1000  on line 29 of form 1040 and $1500 on line 20.*

Q2a. What is the purpose of this number anyways?

A2a, It's TT allocating money for the calculations. So, yes it's usually $4000. But, it isn't always needed. 

Q3. I want to make sure that I am NOT double-dipping for the $1k for the textbooks since it is in two places.

A 3. Yes, one place or the other, but not both.  Telling you to use $33K, assumed no other entries would be made. You want TT to end up with $33K on line 8r of Schedule 1. 

Q4. Line 17 Used for Credit on my Son’s  worksheet, is blank (doesn’t even show a 0).  Is this correct?

A4. Yes. $0 was entered in box 1. There is no tuition to allocate to the credit or the scholarship. 

Q4a. The first time I had entered the 1098T information for him a few weeks ago, I had seen an input screen for “Education Expenses Used for a Tax Credit” which said “…if the person who claimed you as a dependent also claimed AOTC for these expenses, then you need to enter $4,000 in the box below in order to calculate education credit.”  However, this screen doesn’t show up in his TT, so I cannot enter the $4k in the box. I hope TT is calculating it correctly.

A4a. That's if you do it the long way and let TT crunch all the numbers. Using the one number entry short cut avoids all that.  TT is doing it correctly, if it enters $33K on line 8r, of schedule 1. 

Q5. Do we need to attach a statement to our tax returns (at least my Son’s return), to clarify why there is additional scholarship income on his Sch 1 that is in excess of what is shown on Form 1098T?

A5. No. This is a very common situation. The IRS does not try to match box 5 numbers. 

*Line 20 may include other credits, if it's more than $1500, look at line 3 on schedule 3.  

[Luna_Tax]

Thank you so much for all your help.  I believe I finally have a decent grasp of this mumbo-jumbo education expenses. Our education tax credits do show up on line 29 & Sch 3, line 3, as you had mentioned. 

I wanted to ask you to please ask the TT people on our behalves that they should include detailed explanation of the treatment of education tax credits, eligible education expenses, scholarships, and Forms 1098T and 1099Q for both the parents and the students in the TT Help sections. They need to include guidance similar to these forum discussions with detailed explanations and examples, and TT should also provide a link to the "better" discussions on this topic in its TT forum. Thank you again.

[JotikaT2]

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