Because all 529 distributions "ARE" taxable income *initially*. It's taxability is offset by the qualified education expenses it is used to pay for. Any excess is taxable income to the student. Read the below, and pay particular attention to what's in italicized bold text.
1099-Q Funds
First, scholarships
& grants are applied to qualified education expenses. The only qualified
expenses for scholarships and grants are tuition, books, and lab fees. that's
it. If there is any excess, then it's taxable income. It automatically gets
transferred to and included in the total on line 7 of the 1040.
Next, 529/Coverdell funds
reported on 1099-Q are applied to qualified education expenses. The qualified
expenses for 1099-Q funds are tuition, books, lab fees, AND room & board.
That's it. If there are any excess 1099-Q funds, they are taxable. The amount is
included in the total on line 7..
Finally, out of pocket
money is applied to qualified education expenses. The only qualified expenses
for out of pocket money is tuition, books, and lab fees. Room & board is
NOT a qualified expense for out of pocket money. As of this writing,
(3/26/2019) congress as not renewed the out of pocket expense deduction, which
expired in 2017.
When you have a 1099-Q it
is extremely important that you work through the education section of the
program in the order it is designed and intended to be used. If you do not,
then there is a high probability that you will not be asked for room &
board expenses, and you could therefore be TAXED on your 1099-Q funds.
Finally, if "all"
qualified expenses are covered by scholarships, grants, 1099-Q funds and there
is ANY of those funds left over, the left over excess is taxable. While the
parent can still claim the student as a dependent, it is the student who will
report all the education stuff on the student's tax return. That's because the
STUDENT pays the taxes on any excess scholarships, grants and 1099-Q funds.
