Retirement tax questions

OK, I have to eat crow. I went back to ChatGPT to see if my understanding of the No Double Benefit Allowed bullet 3 applied. I had believed it didn't because of the two links at the bottom of the bullet item. In order to help anyone else that might have this issue, I will append the full answer from ChatGPT after my state return question on the same topic.

KrisD15, thank you for your help in getting me through this. My apologies.

Going through with the LLC and additional taxable income is the better option for the Fed. However, with the state (Oregon) it looks like the excess income does not get offset by a state LLC. Is this what you would expect?

From ChatGPT. 

This is a great question, and I can see why the third bullet point is raising doubts. Let’s break it down carefully.

What This Rule Means

The third bullet point says:

"Claim a lifetime learning credit based on the same expenses used to figure the tax-free portion of a distribution from a ... qualified tuition program (QTP)."

This means that you cannot "double dip" by using the same tuition expenses to both:

1. Justify tax-free treatment of your 529 (QTP) withdrawal, and
2. Claim the LLC for those same expenses.

Does This Apply to You?

The key question is: Are you using the same expenses for both?

• The Qualified Education Expenses (AQEE) for your 529 withdrawal were $12,699.
• The QTP distribution was also $12,699 (earnings + basis).
• The IRS says that to claim the LLC, you must set aside at least $2,000 in expenses that are NOT being used to justify tax-free QTP treatment.

So if your entire QTP distribution is tax-free based on the full $12,699 of AQEE, then you don’t have any "leftover" expenses to justify the LLC. That means TurboTax is actually correct in taxing a portion of your QTP withdrawal.

What Should Happen?

To get the full $2,000 LLC, you need to remove $2,000 from the AQEE used for the QTP calculation. This means:

• Your AQEE for the 529 distribution would now be $12,699 - $2,000 = $10,699.
• The $2,000 now qualifies for the LLC.
• But this reduces your AQEE below your QTP withdrawal, meaning part of the earnings from the 529 becomes taxable.

How TurboTax Likely Got $7,296 as Taxable Income

TurboTax is probably reallocating the education expenses as follows:

• $2,000 of expenses goes toward the LLC
• Only $10,699 is left for the QTP to be tax-free
• Since your QTP withdrawal was $12,699, TurboTax is taxing the earnings portion of the "excess" $2,000 distribution (likely around 57.5% of it, based on your earnings-to-total ratio, which gets you close to $7,296).

Final Answer: TurboTax Is Probably Right

• If you take the LLC, part of the QTP earnings must become taxable.
• If you want all of the QTP earnings to remain tax-free, you cannot take the LLC.
• So you can’t have both the full $2,000 LLC and $0 taxable income from the QTP.

Your Choices:

1. Take the LLC and pay tax on some QTP earnings

   • Keep the $2,000 LLC, but expect some of the 529 earnings to be taxable.
   • This is usually still the better financial outcome because the LLC is a dollar-for-dollar tax credit, while QTP earnings are taxed at your marginal tax rate (which is lower than a credit).

2. Skip the LLC and keep the QTP earnings tax-free

   • If avoiding taxable income is a priority, don’t claim the LLC, and all $9,268 QTP earnings stay tax-free.
   • But you lose the $2,000 tax credit, which is likely a worse outcome.

My Recommendation:

Even though TurboTax was frustrating, its calculation was likely correct based on how the IRS coordinates QTP withdrawals with education credits. You should probably claim the LLC and just pay the small tax on QTP earnings—you’ll still come out ahead financially.