TurboTax said I didn't need to file 1099-Q, IRS wants taxes on earnings distributed (2020 Taxes)

[ddessert]

Summary: TurboTax said we didn't need to file a the 1099-Q we received from Fidelity, but the IRS now says we owe taxes on the Earning portion of the 529 plan distribution. Advice on how to resolve?

My non-dependent son paid tuition to the community college which we reimbursed later from our 529 Plan through Fidelity. My son files his own tax return and is not listed on our return. His school did provide a 1098-T to him covering the distributed amount.

Fidelity provided a 1099-Q with Box 6 checked ("If this box is checked, the recipient is not the designated beneficiary") to my wife (the owner of the QTP/529 Plan). The actual beneficiary's name/info (our son) is not mentioned on the 1099-Q form.

Going through the TurboTax 2020 questions step-by-step:

Q: Were you the beneficiary of a Coverdell Education Savings Account (ESA)?  No

Q: Did you receive a Form 1099-Q for distributions from a Coverdell ESA or a qualified tuition program (QTP)?  Yes

Q: Who's shown on as the Recipient on your 1099-Q?  Someone else not listed here

Q: Who's the student?  Someone else not listed here

Great news! You don't need to report this form

As advised, we filed our 2020 taxes without the 1099-Q.

Now the IRS has written us claiming we did not report the Earnings portion of the 1099-Q (line 2) and we owe taxes on those earnings. The 1099-Q has box 6 checked showing that my wife was not the beneficiary of the distribution, and the true beneficiary name/info (our son) is also not listed on the 1099-Q.

I need to resolve this with the IRS and I feel like the same situation will happen with my 2021 tax return as we filed the same way this last year.

[Hal_Al]

You say "My non-dependent son paid tuition to the community college which we reimbursed later from our 529 Plan through Fidelity."

I assume two things: he is the beneficiary of the 529 plan and the 529 distribution was in the same calendar year that the tuition was paid. 

You've done nothing wrong (nor has TurboTax [TT]). We're seeing this frequently (it happened to me, personally). Apparently, the IRS has created a problem by not having a form to report the situation where the taxpayer uses all the 529 plan distribution for qualified expenses. Even if you had entered the 1099-Q in TT, nothing about the 1099-Q would have gone anywhere on the actual IRS forms.

You should reply to the IRS that it was all used for qualified education expenses. I attached a copy of my billing statement from the school  and that took care of the problem (2-1/2 months later).

But be aware, you cannot double dip. Your son cannot count the same tuition money, for the tuition credit,  that gets you the exclusion from the taxability of the earnings (interest) on the distribution. 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. Room & board are also qualified expenses for a 529 distribution (if the student is half time or more).

At least two other users have reported receiving a CP2000 letter, from the IRS,  on 529 distributions. They replied that their child was in college and the distributions were for qualified expenses, which they listed, but they did not provide receipts.. They  later received a notices saying they were in the clear.

[Hal_Al]

As an aside (it should not matter), it sounds like you made an error in Turbo Tax (TT).  You say:

"Q: Who's shown on as the Recipient on your 1099-Q?  Someone else not listed here"

That's probably not correct. YOU are the recipient, if your name and SS# are on the 1099-Q.  But, as previously indicated, 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.  So, the result would have been the same.

If your son was the recipient, he should have entered the 1099-Q, on his return. But, again, the result would have been the same, nothing about the 1099-Q would have gone on the actual tax forms.

[ddessert]

Thanks for pointing out my oversight! It does work out as no additional taxes although the 1099-Q and a worksheet are also generated.

I also called Fidelity who said that since my son was the direct recipient of the funds from Fidelity, his name should be on the 1099-Q form and not my wife's. That would also take it off my tax return altogether but probably force him to add it to his.

At this point, it may be just as well for all involved to file 1098-T information with the IRS and put it to bed. Same outcome and less work for everyone involved (me, my son, and the IRS).

[Hal_Al]

You said "Fidelity who said that since my son was the direct recipient of the funds from Fidelity, his name should be on the 1099-Q form and not my wife's".  That's probably not correct because you said earlier "The actual beneficiary's name/info (our son) is not mentioned on the 1099-Q form" and " we reimbursed later from our 529 Plan".

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student  who may or may not also be a  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.

**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.

[Hal_Al]

Qualified Tuition Plans  (QTP 529 Plans) Distributions (also applicable to ESA 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.