Q.Is it correct that the earnings portion of the 529 plan distribution should be reported as unearned income on my daughter’s tax return?
A. Yes, if she is the recipient (see below*). The grandparents have the option of requesting the fund send the money to her, them or the school.
Q. Is it correct that long term capital gains will have a 0% tax liability (because her earned income is less than $39,000), and that short term capital gains will have a 10% tax liability up to the first $12,000 in earnings?
A. No. 529 distributions are treated as ordinary income; even though the earnings, within the fund, may have originally come from capital gains and/or qualified dividends.
Q. Can I expect earnings to be broken down into short- and long-term capital gains and dividends on her 1099Q?
A. No. The distribution will just be reported as earnings (box 2 of the 1099-Q) and basis (box 3). The total distribution will be in box 1. The box 2 amount is the taxable amount.
Q. This all seems so complicated.
A. It is and it gets more complicated. Another alternative is have the student report some of her scholarship** as taxable income, to free up some expenses for the 1099-Q and/or tuition credit. Taxable scholarship is treated as earned income for purposes of the standard deduction (but not the "kiddie tax"). The student gets a $12,400 deduction, instead of only $1100.
Another issue: Room and board, are qualified expenses for a 529 distribution (but not for a tax credit or tax free scholarship).
*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.
**There is a tax “loop hole” available. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship. You cannot do this if the school’s billing statement specifically shows the scholarships being applied to tuition or if the conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
