We used a state qualified tuition program to pay for college tuition. Why are we being taxed for the "earnings" on the 1099-Q form? I thought this was tax free money

[day2z]

We did enter a 1098T form as well.

[Carl]

The only portion that is tax free is the amount used to pay for "qualified" education expenses, and some of those unqualified but allowed expenses that were paid "in direct support" of the education.  More details in the answerbox below. Pay attention to what is in bold italicized print.

[day2z]

ok, but our 1099Q shows distrution in box 1, earnings in box 2, and basis in box 3 (and the taxable amt is what's showing as the earnings in box 2.  Was I supposed to enter in the room & board costs on Turbo tax?

[Carl]

Yes. In fact, if you will work through the education section they way it's designed and intended to be used (as stated in my answer below) the program will ask you specifically for room and board expenses. Now remember, the "room" part includes more than the rent. It includes the cost of utilities also. Then the "board" part is the cost of food.
Note that room and board is only deductible for the months it was paid "in direct support" of the education. For example, if the student was not enrolled for the summer semester (generally June-Aug) then room and board paid in those months was not paid "in direct support" of the education. Therefore it's not deductible.

[Carl]

1099-Q Funds

 First, scholarships & grants are applied to qualified education expenses. The only qualified expenses for scholarships and grants are tuition, books, and lab fees. that's it. If there is any excess, then it's taxable income. It automatically gets transferred to and included in the total on line 7 of the 1040.

Next, 529/Coverdell funds reported on 1099-Q are applied to qualified education expenses. The qualified expenses for 1099-Q funds are tuition, books, lab fees, AND room & board. That's it. If there are any excess 1099-Q funds they are taxable. The amount is included in the total on line 7..

Finally, out of pocket money is applied to qualified education expenses. The only qualified expenses for out of pocket money is tuition, books, and lab fees. Room & board is NOT a qualified expense for out of pocket money. As of this writing, (3/26/2019) congress as not renewed the out of pocket expense deduction, which expired in 2017.

When you have a 1099-Q it is extremely important that you work through the education section of the program in the order it is designed and intended to be used. If you do not, then there is a high probability that you will not be asked for room & board expenses, and you could therefore be TAXED on your 1099-Q funds.

Finally, if "all" qualified expenses are covered by scholarships, grants, 1099-Q funds and there is ANY of those funds left over, the left over excess is taxable. While the parent can still claim the student as a dependent, it is the student who will report all the education stuff on the student's tax return. That's because the STUDENT pays the taxes on any excess scholarships, grants and 1099-Q funds.