Q. Which of these is the owner, the beneficiary, and the recipient?
A. The student is always the beneficiary. The grandparent is always the owner. The recipient is the grandparent (a middleman, you, can not be the recipient). At tax time, there needs to be coordination, between the three parties, on how the expenses will be allocated. If the distribution went to the school (the student is the recipient), then the grandparent is out of the picture at tax filing time.
Q. I'm not clear on the $4,000. Do you mean that we should cover $4,000 of the tuition out of our own pockets.
A. Yes. Or, at least, that is the simplest way. There are some workarounds. Paying a little tax on the distribution or having the student declare some of his scholarship taxable (particularly if he has little or no other income). The first$14,600 of scholarship and wage income does not get taxed.
Q. Does this give us a tax benefit next year?
A. Yes. Unless your income is too high (>$180K married), the parents, of a dependent student, are allowed a tuition tax credit (not a deduction) of up to $2500. It only takes $4000 of tuition to claim the maximum credit.
Q. What does all of this mean regarding my original question: Is the way we're doing this still "safe" for tax purposes.
A. Yes. There will be no repercussions from a tax standpoint.
Q. Is it better to have the funds directly transferred from my mom's fund to the school, rather than have the funds pass through our bank account?
A. Simple answer: No. It makes no difference when all the 529 distribution amount is covered by qualified expenses. Nothing gets reported on anybody's tax return. Otherwise, maybe a little. Even when some of it is taxable, it gets taxed approximately the same either way, depending on the tax brackets of the grandparents and parents, and what other income the student has. Sending the distribution directly to the school, you avoid the hassle of the grandparent having to file a return. If any of it goes on the student return, the kiddie tax applies above $1300. If the student has no other income, the first $1300 of reportable earnings would not get taxed (whereas it would, most likely, get taxed on the grandparent's return).
I know that sounds complicated (see below the line for more complicated detail). It may come down to this: the convenience of having control of the money (if it comes to you first) vs the possibility (not probability) of a little tax and different filing complications. In particular, you'll have control over the timing of the distribution(s), maybe allowing you to more accurately match the amounts of your expenses.
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Qualified Tuition Plans (QTP 529 Plans) Distributions
General Discussion
It’s complicated.
For 529 plans, there is an “owner” (usually the parent, but sometimes a grandparent), 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.
