While all of the responses in this thread are correct, none of the responses are all-inclusive so as to provide a clear and concise answer, thus removing the ambiguity.
- If the total of all tax free/exempt education assistance from all sources combined exceeds the qualified education expenses, then you "MUST" report it "ALL" on your tax return. Period.
This includes (but is not limited to) scholarships, grants, 529/Coverdell distributions, Pell Grants, Employer provided education assistance, and anything else provided to fund the "qualified" education expenses of the student.
Example:
Sally has qualified tuition expenses of $5000
Sally got a scholarship for $3000 and a 529 distribution for $3000.
While the 529 distribution does not exceed her qualified expenses, the total of all education assistance received from all sources *DOES* exceed her qualified expenses.
Now you would think (and you would be correct in your thinking) that since you used the 529 funds for room & board while sally was in school, you don't need to report it since it's tax free anyway. The fact is, you'd be right. But the IRS doesn't think t hat way, and their computers most definitely don't think that way.
When you claim the $2000 out of pocket expenses, the IRS is going to "know" you got that $3000 529 distribution because they have a copy of the 1099-Q that was sent to you. That's going to generate a computer generated letter to you from the IRS (basically, a nasty gram) denying you your $2000 out of pocket expense deduction, because of the 529 you did not report.
However, if you report that $3000 529 distribution on your tax return and indicate that the entire distribution was used to pay Sally's rent for the period of time she was in school, you'll still be able to claim (and will get) your $2000 out of pocket expense deduction. That makes the entire 529 distribution tax free since it was all used for the unqualified but "allowed" expense of room and board, since that room and board was "in direct support" of Sally's education.
This will negate you getting a nasty gram (which will delay your refund for weeks, if not months) from the IRS, inquiring about what you did with the 529 funds.
SO when it doubt, report it.
