The IRS is wrong (it happens frequently, particularly with this issue). You should write back to the IRS with the explanation you described above. You should provide some detail on the $12,000 of expenses and preferably receipts (school bills).
Your calculations are a little wrong. Line 6 of the work worksheet is the non taxable portion of the earnings. Line 7 is the taxable portion (total earnings on line 4 minus nontaxable earnings on line 6). Also, $12,000/$20000 = 0.60, not 0.5454)
- The ESA/QTP Worksheet should show the following:
- Line 4: Total distributed earnings from Form 1099-Q: $8500
- Line 5: Fraction - divide qualified expenses by total distribution ($12,000/$20000 = 0.60)
- Line 6: Multiply line 4 by line 5: 8500 x 0.60 = $5100
- Line 7: Subtract line 6 from line 4: 8500 - 5100 = $3400 (taxable amount). This is the amount that shoulda went onto your TurboTax return on Line 8 of Schedule 1 , Other Income.
Another way to look at it: Your non qualified (excess) distribution is $8000. $8000 / 20,000 = 40%. 40% of the $8500 earnings is taxable. 0.40 x 8500 =$3400. There will be a 10% penalty on the $3400, unless you qualify for an exception (you used expenses for a tuition credit and/or they were paid by tax free scholarship.
Room and board, even if living off campus (or at home), are qualified expenses for a 529 distribution (but not for a tuition credit or tax free scholarship).
