Q. What steps do we need to take to avoid having 529 funds appear as income?
Room and board are only qualified expenses for a 529/ESA distribution. R&B are not qualified for the education credit or tax free scholarship. If the student lives off campus, your qualified R&B expenses are limited to the lesser of your actual costs or the school's "allowance for cost of attendance" (COA). There is a separate COA for students living at home
Allow for $4000 of tuition and fees to not be covered by a 529 distribution or scholarships, so that you can claim the tuition credit.
Be sure your distributions are taken in the same year as the expenses were incurred. A common error: you take a distribution in December to make a payment in January. That will not be a "qualified distribution".
For 529 plans, there is an “owner” (usually the parent, but the grandparent in this case), 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, if it needs to be reported.
The 1099-Q is only an informational document. The numbers on it are not required to be entered onto your (or your student's) tax return.
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. 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 (you don’t need it). You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. You also cannot count expenses that were paid by tax free scholarships.
