TurboTax taxing a 529 distribution

[djb52]

This year I had my son pay for college out his own accounts, then he gets reimbursed from the 529.

The amount of the distribution is identical to what he spent on college, and both the 1099-Q and the 1098-T have those amounts.

Both are being entered in to TurboTax, yet TT seems to think the entire amount is taxable.

I'm a little stumped.  I see there are other posts that say that you can simply not file, but I'm a little concerned why TT seems to be doing this incorrectly for such a simple and common thing, unless there's truly something I'm doing wrong.  

Anyway, thanks for any insights you can provide.  Worst case, we'll probably just not report the 1099-Q, since all the expenses are qualified.

[Hal_Al · Accepted solution]

One possibility is that TurboTax allocated some of your dependent's college expenses to  the Tuition credit, even if you are not eligible or were otherwise not claiming it. That reduces the amount that can be used to claim the  529 earnings, shown on the 1099-Q, as being totally tax free. Go through the entire education interview until you reach a screen titled "Your Education Expenses Summary".  Click edit next to the student's name. That should take you to a screen “Here’s your Education Summary”. Click edit next to “Education Information”. When you get to the screen titled “Amount Used to Calculate Education Deduction or Credit”, verify the amount you want to use or change it.  You may reach that screen sooner.

Another possibility is that TT allocated some of the expenses to scholarships.

Read on for more, particularly about claiming the tuition credit

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

 =$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 $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360)

**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.

[djb52]

Awesome.  Thank you.  It was assuming that I would be taking a tax credit, but I don't believe I can any more because we've taken if 4 years.  At least, I had it in my mind somehow that we were done, and we need to leverage the 529.  I think if we'd just gone through all those wizards, we would have spotted it.

Thanks so much!

[Hal_Al]

Even though you've claimed the American Opportunity credit the maximum 4 times, you should still be eligible for the Lifetime learning credit (LLC). It's worth 20% of your tuition up to $10K.  Depending on your tax bracket (or your student's bracket), it may be better to pay a little tax on his scholarship or the 529 distribution.

Essentially most students don't pay any tax on the first $12,400 of taxable scholarship. 

[djb52]

The situation with us is that we oversaved in to the 529, so we're trying to use as much of it as we can.  With the American Opportunity, the first $2000 was 100%, so had to use that, but I chose NOT to use the 2nd $2000 at 25% for this reason.

[SweenDawg]

@Hal_Al Thanks for the explanation.  This is just criminally stupid on Turbo Tax to bury the credit allocation that way.  My daughter was doing her own taxes but is still my dependent.  Because I have no chance at any tax credit, the full amount of expenses need to be allocated to her.  To bury it in a place they don't require you to visit and assume I am taking that credit almost got my daughter to overpay taxes if I hadn't looked it over and said it couldn't be right.  I never would have found it without your help .

[kimo20]

All my distributions from my daughter's 529 are qualified, thus tax free. As the parent, I am filing form 1098-T on my taxes & am getting the American Opportunity Education credit. Therefore, is it necessary to file Form 1099-Q on my daughter's taxes? I'm having the same problem as others here, where she is having to pay in bc TT is taxing the earnings listed in the 1099-Q. 

I am also unable to list education expenses on her tax form without being prompted to enter Form 1098-T. Having entered it on my taxes, I am assuming I shouldn't enter this Form 1098-T on her taxes.

[ThomasM125]

@kimo20 Your daughter does not need to enter the 1099-Q on her tax return if you know the distribution was made for qualifying education expenses, which includes room and board expenses in the case of the 1099-Q distribution. The problem is that she can't use the education expenses that you used for your education credit to also exempt the education plan distribution from taxes. 

If you have an American Opportunity Credit, the first $2,000 represents $2,000 worth of qualifying expenses. The rest represents 25% of your expenses, up to $2,000. So, if you had a credit of $2,500, you would have used up $4,000 worth of education expenses. The rest would be available to exclude your 1099-Q distribution from taxation. 

If you have a lifetime learning credit, it is 20% of your education expenses, up to $10,000 of expenses.

So, you can do a manual calculation to see if any of your 1099-Q is taxable, and if not just exclude the entry on your daughter's tax return.

[kimo20]

Thanks! Your example in the above post helped me calculate it out. So apparently $932 is taxable. We were under the impression none of our distributions from our 529 plan were taxable as long as they were qualified withdraws, which they were.

So, just to confirm, I would need to go through this calculation next year also in order to determine what is taxable. Or is this manual calculation only necessary since we claimed an Education Credit?

[DianeW777]

Yes.  As long as you are using the education credits, you should calculate the amount available to use from the 529 funds without taxation before distribution if possible.  If not, then you could have a taxable portion as you do this year.

[Discovery1]

Thank you for that thorough explanation.. although I'm thankful for your expertise it is infuriating that this type of tax item is so incredibly complicated. Another example of the tax code being bloated and difficult to implement.. no wonder tax (correction) services are advertised day and night.

[KrisD15]

Education expenses, payments, and credits are complicated because there are options to how you can allocate everything. 

In my opinion, "Understanding Education Credits" should be a mandatory first quarter college class. 

IRS Pub 970

[Pulegone]

TT determined that my child cannot be claimed as my dependent, but she was a fulltime student for half of the year (spring grad).  So she is filing separately. When we enter her tuition expenses and 1099-Q, she is  penalized for it and her refund goes down significantly.  The total tuition paid that we entered is more than the 529 distribution.   What are we doing wrong?

[MarilynG1]

Generally, a student can be claimed as your dependent.   If they are filing as a non-dependent, this means they paid their own rent, etc. with Earned Income (paying their own expenses with loans/grants, etc. does not count as supporting themselves).  However, you can still claim them as your dependent no matter what their income is, if they are under age 24 and a full-time college student. 

If your child did indeed support themselves with their income, and their Qualified Education Expenses (including Room & Board) exceed their scholarships and 529 distributions, they don't need to enter the 1099-Q in their return.  Save documentation of expenses paid.  Here's more info on Form 1099-Q. 

If this applies, it could be your entries in TurboTax are causing the issue.  Here's more info on Claiming Student Dependents and Reporting Education Expenses. 

[Hal_Al]

Q. What are we doing wrong?

A. You're entering the 1099-Q when you don't need to.  TurboTax doesn't handle this easily. 

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. 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. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. You also cannot count expenses that were paid by tax free scholarships. You cannot double dip! 

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." 

___________________________________________________________________________________

Can she claim the tuition credit? Did you already claim the American Opportunity credit (AOC), on her education, the maximum 4 times? If so, the less generous Lifetime Learning Credit may not be better than taking the 529 exclusion.  Who was the recipient of the 1099-Q?  The 1099-Q would go on your return, if you are the recipient, even if she is not your dependent (if it even needed to be entered).

___________________________________________________________________________________________

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 (or she, if not your dependent) can and should claim the AOC 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 (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.