Why did my scholarship decrease my Adjusted Qualified expenses and create Other Income (taxable) for the proportionate portion of earnings from a 529 withdrawal?

[lottavio1]

Withdrew from 529 to cover "payments received for qualified tuition" on 1098-T, but that 529 withdrawal was adjusted by the separate scholarship resulting in taxable Other Income ("Qualified State Tuition Program").

[Hal_Al]

Q. Why did my scholarship decrease my Adjusted Qualified expenses and create Other Income (taxable) for the proportionate portion of earnings from a 529 withdrawal?

A. You are not allowed to "double dip".  That is, you may not use the same expenses that make your scholarship tax free to also claim that your 529 withdrawal is tax free (or qualifies you for a tuition credit).

Tuition, fees, books and a computer are qualified expenses for a tuition credit,  529 withdrawal  or tax free. Room and board are only qualified for the 529 withdrawal. 

There are three things you can do with your Qualified educational expenses (QEE):

1. Allocate then to scholarships (so that the scholarship remains tax free)
2. Allocate them to the 529 distribution (1099-Q) so that it will not all be taxable
3. Use them to claim an education credit

TurboTax allocates QEE, in that order, but it doesn't do a very good job if you want something different. TurboTax allocates QEE, in that order, until you tell it otherwise.  It's best if you have some idea of the outcome expected, when you make your entries. 

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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), 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 $13,850 of taxable scholarship (in 2023) and still pay no income tax. 

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Provide the following info for more specific help:

• Are you the student or parent.
• Is the  student  the parent's dependent.
• Box 1 of the 1098-T
• box 5 of the 1098-T
• Any other scholarships not shown in box 5
• Does box 5 include any of the 529/ESA plan payments (it should not)
• Is any of the Scholarship restricted; i.e. it must be used for tuition
• Box 1 of the 1099-Q
• Box 2 of the 1099-Q
• Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)?
• Room & board paid. If student lives off campus, what is school's R&B on campus charge. If he lives at home, the school’s R&B “allowance for cost of attendance” for student living with parents.
• Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers
• How much taxable income does the student have, from what sources
• Are you trying to claim the tuition credit (are you eligible)?
• Is the student an undergrad or grad student?
• Is the student a degree candidate attending school half time or more?

[lottavio1]

Thank you for your detailed response! I am providing the following info for more specific help:

- I am the parent (married, filing jointly)

- the student is our dependent

- Box 1 of 1098-T = $18,843 (plus another small one for the same kid for $225, with no scholarship / Box 5 amount)

- Box 5 of the 1098-T = $8,500

- no other scholarships, besides the $8,500 shown in Box 5

- Box 5 is solely the school-given scholarship - was not factored in to the 529 withdrawal

- the $8,500 scholarship ($17,000 for the academic year) directly reduced the tuition we were charged

- Box 1 of the 1099-Q = $18,784 (ie: approx what we paid the school out of pocket, after the scholarship was deducted)

- Box 2 of the 1099-Q = $7,178

- parent's name and SS# are on the 1099-Q (parent is "recipient) - student's name and SS# are showing on the 1098-T from the school

- room and board paid is included in the $18k in Box 1 on the 1098-T (not sure if it should have been, but that is how the school issued the 1098-T and the 529 withdrawal was based on that)

- other qualified expenses not included in box 1 of the 1098-T: there would have been book expenses, but those were not calculated nor considered for the 529 withdrawal

- student had almost $4k of AGI (from part time jobs, W-2s), so taxable income of $0 after standard deduction - all education related expenses/credits/etc are on the parents' tax return; no education impacts were included on the child's/dependent's return (Maybe that needs to be changed?)

- tuition credits calculated by TurboTax are $1,314 American Opportunity Credit for this child, and $18 Lifetime Learning Credit for another child (= $1,332 total) - shows $523 in Refundable American Opportunity Credit and $809 in Nonrefundable Education Credits. TurboTax advised to play with amounts within a range to maximize the benefit (between taxable distribution amount and education credit) - the maximum in the range of $4,000 gave the best benefit (ie: highest tax refund)

- student is an undergrad

- student is a degree candidate attending school full time

So, my question pertains to the Other Income ("Qualified State Tuition Program from 1099-Q") of $4,668 that I am being taxed on Federally as well as by New York State - calculated as follows:

Total Expenses $19,068 = $18,843 + $225 per 1098-Ts

Used for credit    (4,000) - as explained above

Scholarship          (8,500) - which is the portion I don't understand - what we withdrew from the 529 is for                                                            expenses paid out of pocket after this scholarship had already been accounted                                                        for;  so why is it generating taxable other income if the scholarship is supposed to                                                    be "tax free"? - we withdrew $18.8k which is what the 1098-T shows were                                                                   "Payments Received"

                                 _______

Adjusted Qual-

ified Expenses    $6,568

Therefore, Excess Distributions are $18,784 - $6,568 = $12,216. 

Total distributed earnings from Form 1099-Q box 2 = $7,178

$6,568/$18,784 = 34.97%

$7,178 x 34.97% = $2,510

Earnings taxable to recipient = $4,668

If the $8,500 scholarship did not decrease Adjusted Qualified Expenses, the Earnings taxable to recipient would only be $1,420 (unless the $4,000 used for credit would change??).

Thank you again for your help!

[Hal_Al]

Q. So why is it generating taxable other income if the scholarship is supposed to be "tax free"?

A. Because the scholarship is only tax free if it is used to pay qualified expenses (tuition, fees, books and a computer, but not room and board). So, the amount of qualified expenses for the 529 distribution has to be reduced by the amount paid by scholarship. Note that TT will deduct the box 5 amount from the box 1 amount when calculating/allocating expenses.

TurboTax (TT) is doing it correctly; $4668 is the taxable amount of the distribution, based on the numbers you input. 

Your own calculations verify this. $19,068 of qualified expenses (18843 + 225 = 19068) less $8500 paid by tax free scholarship, less $4000 used for the American Opportunity Credit = $6568 of adjusted qualified expenses for the 529 distribution.  6568/18784=34.97% of the earnings are tax free; 65.03% are taxable.  0.6503 x $7178 = $4668..

Three seems to be some question as to the accuracy of your numbers.  Room and board should not be in box 1 of the 1098-T. Although it has been known to happen, the school should know better.  You should review your billing statements. It appears that you should be entering room and board expenses in addition to the 1098-T. The fact that you say you paid $18,784 out of pocket supports that. In addition, don’t ignore book and computer expenses just because you didn’t include them in your 529 distribution. They can still be used to reduce the taxable portion.

Since the student only has $4000 of income, you also have the option of him reporting some or all of the $8500 as taxable scholarship income. This will free up $8500 of expenses for the 529 distribution. He will still pay no tax because taxable scholarship is treated as earned income for the calculation of a student’s standard deduction.

[lottavio1]

Thanks again for your reply! Are you suggesting that the $8,500 scholarship can be reported on the student's tax return while the remainder of the Form 1098-T amounts can be reported on our (the parents') return - ie: the amounts can be split between returns as long as all amounts are reported on one return or the other? If so and after making this change, the student does not owe any Federal Tax (as you predicted), but does now owe NY state taxes (due to the Other Income generated). However, this is more than offset by the decrease in our (the parents') Federal taxes owing (due to the decrease in our Other Income). Our NY State taxes remain unchanged (Other Income decrease offset by NY 529 deduction/earnings decrease - so no impact). The 1098-T was issued in the student's name. However, he is our dependent and we paid the college expenses and the 529 beneficiary is his father. 

[Hal_Al]

Q. Are you suggesting that the $8,500 scholarship can be reported on the student's tax return while the remainder of the Form 1098-T amounts can be reported on our (the parents') return - ie: the amounts can be split between returns as long as all amounts are reported on one return or the other?

A. Yes.  The results you are seeing are typical.

The 1098-T is only an informational document. The numbers on it are not required to be entered onto the student's  tax return, just because it is in his name. 

If so and after making this change, the student does not owe any Federal Tax (as you predicted), but does now owe NY state taxes (due to the Other Income generated). However, this is more than offset by the decrease in our (the parents') Federal taxes owing (due to the decrease in our Other Income). Our NY State taxes remain unchanged (Other Income decrease offset by NY 529 deduction/earnings decrease - so no impact). The 1098-T was issued in the student's name. However, he is our dependent and we paid the college expenses and the 529 beneficiary is his father.

You said "the 529 beneficiary is his father".  I assume you meant the recipient of the 529 distribution (form 1099-Q) was his father.  The 1099-Q is also only an informational document and is not required to be reported.  But, if it does need to be reported, it goes on the recipient's return.