529 early withdrawal

[ericlipkind]

I am a bit confused as to how Turbotax is calculating taxable income on an early withdrawal from a 529.  Using the below example, if I had a $100,000 distribution and $50,000 of the distribution was earnings, and had $25,000 of education expenses, why is Turbotax allocating the education expenses against the total distribution and giving taxable income of $37,500?

It was my understanding that there would be a 10% early withdrawal penalty on $75,000 (distribution minus education expense) and then the expenses would go dollar for dollar against income (earnings minus education expense) giving $25,000 taxable income in the example above.   

Since the $100,000 distribution was contributed originally post-tax, this does not make sense that some of that income would be taxed again given how Turbotax is calculating.

Can someone please explain to me?

[Hal_Al]

 25,000 of expenses divided by $100,000 distribution =25% of the earnings are tax free and 75% are taxable (and subject to the penalty. 0.75 x 50,000 = $37,500

TurboTax will  usually assume that some (usually $10,000) of the expenses were used to claim an education credit. That leaves $15,000 of expenses to be used against the 529 withdrawal shown on the 1099-Q.

15,000 / 100,000 = 15% of the earnings are tax free. 0.15 x 50,000 = $7500.  $42,500 (50,000-7500) would be taxable. But only $32,500 would be subject to the penalty (using the money to claim a tuition credit is a penalty exception)

[ericlipkind]

Thanks, but what if AGI is over $180,000 and no credit can be claimed?

[ericlipkind]

Also, isn't the penalty on the entire distribution, not on just earnings?

[Hal_Al]

That's correct, not  tuition credit for you.  Use the first calculation in my answer**.
No, it's just the earnings that are subject to tax and penalty. The other money (basis) was already taxed before it went in (it's "after/post tax" money).

** Be aware, there's a glitch in TurboTax. TurboTax (TT) assumes you will claim a Tuition credit, even  if you are not
eligible. So it reduces the amount used for the earnings exclusion, on the 1099-Q, for the amount used for the credit.
Since  you are not eligible for the tuition credit, you may have to work around TT's assumption.
Go through the education section again. When you get to the screen that says “Here’s your Education Summary”.  Click edit next to “Education Information”. When you get to the screen titled “Amount Used to Calculate Education Deduction or Credit”, verify the amount you want to use or change it.

[ericlipkind]

So in effect, I lose out on deducting half of the education expense due to the allocation? (i.e. I only get to reduce earnings by $12,500 instead of $25,000)

[Hal_Al]

Yes, if you want to look at it that way, but not really. The education expense (the whole 25K)  is applied to the  distribution amount (100K).  That ratio is used to calculate the taxable portion of the earnings.

[ericlipkind]

Now if I had a $100,000 early withdrawal and zero in earnings and zero in education expenses, there would be no penalty since there is no earnings?

[Hal_Al]

That's correct.

[ericlipkind]

thanks