Q I was told that in the case of scholarship I should be able to make penalty free distributions up to the amount of her scholarship per year.
A. Yes, penalty free but not tax free. The box 2 (1099-Q) amount should be showing up as income on Schedule 1, line 8z.
Q. I read that I should be able to claim the penalty exception via form 5329. Where in TurboTax can I do that? That question does not come up during entering 1099-Q.
A. That's correct, when entered properly, TT will generate form 5329 to claim the penalty exception. Also correct, that you are not asked that in the 1099-Q interview.
After entering the 1099-Q, your must enter the 1098-T at the educational expenses section. If the amounts in box 1 and box 5 cover the box 1 (1099-Q) amount, you should not need to enter any other amounts. Be on the look out for a screen called "Amount used to calculate education deduction or credit" TT may have populated this with $4000 or 10,000. Change it to 0. See below for another option. The allocation of expenses will show on the Student information worksheet and the 1099-Q work sheet.
Here's a quicker workaround (or if you run into a snag above). Rather than entering the 1098-T later: at the 1099-Q interview, when asked who the beneficiary is, answer someone not listed here. Then enter your daughter's name at the next screen. That will get a you a simpler screen to enter expenses, in the 1099-Q interview. There are several screens before you get there, including one asking for the level of school the student attended. After entering the expenses, be sure to enter the offsetting amount at "Adjustments: Tax-free assistance" (scholarships).
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A couple of other issues:
1. If the student has a scholarship that also pays for room and board, she has some taxable income. Scholarships that pay for qualified expenses (tuition, fees, books nd other course materials including a required computer) is tax free. But scholarships that pay for room & board and other personal expenses is taxable income to the student. Room and board paid by the student's taxable income/scholarship is eligible for a 529 distribution.
2. You may still be eligible for a tuition credit, even though all the expenses were paid by scholarship.
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.
