How does TurboTax handle 529 withdrawals that are: 1. Not for educational purposes, but 2. Not penalized because the plan beneficiary attends a US Service Academy?

[jadcom]

... is the problem.

[Hal_Al]

@jadcom  said "While still disallowing the savings that should be associated with funds withdrawn for expenses.  And that, specifically, it the problem"

That sounds like you think, in addition to the penalty being waived, the earnings should be tax free?  

Whether you're on a football scholarship at Ohio State or a free ride at USMMA or USMA, a 529 distribution is taxable.  Everyone is treated the same.  If you think that's a problem, your congress member is the person to vent at.  I agree there is some penalty there, as the earnings are taxed as ordinary income, rather than as capital gains. 

If you're just trying to use 529 fund for expenses like books and computers, you'll have to use the scholarship exception, rather that the service academy exception, so you can enter those specific expenses. 

[jadcom]

FORMATTED FOR EASIER READING

A 529 distribution is indeed taxable at ordinary income rates for withdrawals that do not reimburse qualified expenses. But USMMA (Kings Point) is not treated the same as USMA (West Point).

Consider this example: A parent has over-saved for his kid to go to college because the kid went to a Federal service academy. In the given tax year, the parent withdrawals $11,000, made up of $1000 for books, computers, etc., and $10,000 to reinvest elsewhere because he will never have more potential beneficiaries. Academies, under the law, are treated differently:

West Point - This cadet is active duty military, not a "student" under the law, and gets paid a stipend to cover books, computers etc. Further, West Point does not participate in Department of Education financial aid programs, and therefore is not a qualifying institution for tax free use of 529 funds. The full $11,000 is taxable at ordinary income rates, but the law (cited in earlier posts) does not impose the 10% penalty because it is a service academy specifically identified in the text.

Kings Point - This cadet is a student under the law, is only in the Naval Reserves, does not get paid a stipend, but does incur various fees for attendance as well as books, computers, etc. Further, USMMA does qualify for Department of Education financial aid programs and does participate. For our parent who withdrew $11,000, the $10,000 should be taxable at ordinary income rates but without the 10% penalty because USMMA is expressly identified (like West Point) in the applicable statute. The $1,000 expense, however, is tax free because the fees reimbursed qualified expenses at a DoED participating institution. As far as I can tell, TT is failing to recognize this situation.

Finally, I am calling foul for that "free ride" comment.  While midshipmen and cadets at all service academies  incur less monetary expense for their education, they pay in other ways. Life is grueling at academies from sun up to sun down, there is limited privacy, codes of conduct under the UCMJ, and very little free time. All attendees are subject to a 5 year commitment to serve in the Armed Forces at lower pay than they probably could make elsewhere. USMMA cadets can remain in the reserves, but must spend 8 years on a cargo ship or elsewhere in the marine industry. I know college life, and I know service academy life; college is a walk in the park on a sunny day. So stow it with your incredibly ill-informed comment about "free ride."

JADCOM, Esq.

[Macdojo70]

Student received a distribution from a 529 account during 2023 at which time the student was enrolled in a US Military academy.  Understanding is that attendance at a service academy is an exception to the 529 withdrawal 10% penalty, however Turbo tax continues to calculate a 10% penalty although the Student Information worksheet notes in box 2 that the individual attended a Service academy as box "e -military academy is selected".   How can the 10% penalty being calculated be removed as this distribution is an exception to the 10% penalty.

[DMarkM1]

Yes, the 10% additional penalty for withdrawal of 529 earnings not used for education expenses by a military service academy student/designated beneficiary is waived.  TurboTax does remove the 10% penalty in desktop and online versions. You should check Schedule 2, line 8 to verify there is no penalty being applied.  You can use "Forms Mode" in desktop products or the following steps for online versions to "Preview your form 1040".  

1. Select "Tax Tools" in the left hand menu
2. Select "Tools"
3. Select "View Tax Summary"
4. Select "Preview My 1040" in the left hand menu

5.  Scroll down to the Schedule 2, line 8

If you have a desktop product you can also use "Forms Mode" to check form 5329 to verify the Smart Worksheet for line 6 shows the distribution as not subject to the additional tax.

If the penalty is showing up on those forms then revisit the education topic and verify your entries.

In the Education 529 topic after verifying the form information, "uncheck/recheck" the service academy selection. 

[Hal_Al]

Check your form 5329.  I tried it in my desktop Deluxe. Although the 1099-Q worksheet appears to be calculating the penalty amount, form 5329 properly applies the penalty exception on lines 7 & 8 (see the smart worksheet above line 7)