taxed on 529 Withdrawal

[bobw9886]

I funded a 529 college fund for my children by having scheduled monthly withdrawals taken from my checking account directly into the 529 funds. When it came time to pay for college . the easiest thing to do was to directly pay tuition with a credit card, then withdraw the appropriate amount by direct deposit back to my checking account and then make a payment to the credit card. I have just now discovered that because box 6 is checked with me as the recipient, I was taxed on the earnings even though I paid the qualified tuition. Is this correct?

[dmertz]

Box 6 is informational only.  It has nothing to do with determining the taxable amount of the distribution.

If the entire amount was used for qualified education expenses of the designated beneficiary of the 529 account, as appears to be the case here, the distribution is nontaxable.  If TurboTax is determining some amount to be taxable, you haven't properly indicated to TurboTax the qualified education expenses of the designated beneficiary.  Make sure that you have clicked the Continue button on the Form 1099-Q Summary page.

[Carl]

The only qualified education expenses are tuition, books and lab fees. While the category for "lab fees" is rather broad, there are absolutely no exceptions to this. But when dealing with 529 funds the rules are a bit more relaxed.

529 funds can be used to pay for the qualified education expenses of tuition, books and lab fees. Additionally, those funds can be used to pay for the unqualified but allowed expenses of room & board ***PROVIDED*** that room and board is *in direct support* of the education. So if the student was more than 100 miles from home and living on/off campus in the local area of the school, *AND* they were enrolled as a full time student for the semester, their room and board expenses for that semester can be paid with tax free 529 funds.

Now the fall semester is Jan-May so room and board expenses paid with 529 funds for those 5 months would be tax free. However, if the student did not enroll for the summer semester and continued to live on/near the school and pay room and board, then the room/board paid for the summer semester would not be "in direct support" of any education and would therefore not be tax exempt.  Enough of that.

When you have a 1099-Q it is *IMPERATIVE* that you work through the education section of the TurboTax program the way it is designed and intended to be used. Otherwise, chances are high (like 99.99999%) that you will miss the questions asking about unqualified but allowed expenses. This will result in the program treating some (or all) of the 529 funds as taxable income.

[bobw9886]

If I change turbotax and make my daughter the recepient of the 529 funds it removes the tax, but this conflicts with the actual 10-99Q and changes my first name on the top of form 10-40

[bobw9886]

Just found on the student worksheet section VI, I do not qualify for the higher education expense under thecoulmn for 529 plan. Can you confinfirm if there is an income limit that make the earnings taxable?

[dmertz]

If you are not the student, of course you do not qualify.  It's the student, the beneficiary of the 529 account, whose education expenses are qualified to be paid from the 529 account.

If the entire amount of the distribution is used for qualified education expenses of the student who is the beneficiary of the 529 account, the distribution is not taxable.

If TurboTax is treating the distribution as taxable, you have not properly indicated the qualified education expenses paid for the student, or you have not properly indicated the student associated with the distribution that you received.  The key to getting TurboTax to treat the distribution appropriately is properly associating it in TurboTax with the student, regardless of the recipient, and making sure that the information pertaining to the student is entered properly.

Make sure that you are making all entries in step-by-step mode, not in forms mode.  Make sure than any Forms 1098-T are also entered and follow-up questions answered.  All forms need to be entered as received, with no modification.

[See Hal_Al's reply below regarding taking education tax credits instead of treating the 529 plan distribution as nontaxable.  The tax credit will often reduce your taxes more than will reducing your taxable income.]

[Hal_Al]

There is no income limit for claiming an exclusion of 529 plan earnings. As others have said, If TurboTax is treating the distribution as taxable, you have not properly entered the qualified education expenses (or entered the student info).

For 529 plans, there is an “owner” (usually the parent), 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.** The recipient's name & SS# will be on the 1099-Q. You cannot arbitrarily change the "recipient" from you to the student, on your (and/or  the student's) tax return.

**Alternatively; 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. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit.   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, in case of an IRS inquiry.

[Hal_Al]

There is a common situation, where you may actually want to pay some income tax on the 529 distribution. You can claim an education credit, even if the education expenses were totally paid with 529 funds. 

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses you claim for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit. You can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets you an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by tax free scholarship

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q 

Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360)

[bobw9886]

I appreciate your help. I have checked over the step by step 10 times and every thing appears correct and matches the 10-98T and 10-99Q along with all the students info. when I go to forms, the student info worksheet Part VI line 17 shows an amount used for credit or deduction and makes line 20 zero, PartVIII line 2c and 2d are zero in the column for purposes of regular tax but show 8000 in the 10% tax column. 

[bobw9886]

I do not think I am getting any other credits, no amer opportunity, lifetime learning or loan interest or tuition deductions . I am getting the 500 dependent credit for 2018 that replaced the dependent exemptions, child is age 20, . same situation with the 529 earnings on my 2017 return.

[dmertz]

Check to see if your tax return includes Form 8863 and any amount on Schedule 3 line 50.  If TurboTax is using the education expenses for either of these credits and is treating a portion of the 529 distribution as taxable as a result, even though the 10% additional-tax column shows an amount, that portion of the distribution is not actually subject to the 10% additional tax on Form 5329 Part II.

[Hal_Al]

dmertz makes a good suggestion.  Even though you may not have intended to claim a tuition credit, TurboTax (TT) may have allocated some of your college expenses to the credit (we've seen this in the past).

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.