Why 1099-Q distribution is not fully coverd?

[garganan]

I am including my son(freshman collage) as a dependent in my tax return and reporting his 1098-T and 1099-Q in my return. I can not claim any education tax credits as my income is beyond the limit.

But however when I add theses forms in Turbotax, it says that "the student beneficiary must reports $1520 of taxable income from his distribution". The expenses reported on 1098-T in box 1 ($26,263) is higher then the gross distribution ($25,828) on 1099-Q. Only scholarship he has on 1098-T in box 5  is $40.

If qualified expense is higher then the 529 distribution then why it want my son to file return and report the $1520 as taxable income?

[ThomasM125]

Since the education expenses are more than the education plan distribution, then the earnings on the distribution would not be taxable. I'm not sure why TurboTax is saying that, since I can't see what was entered. Since the education plan distributions were used to pay for qualifying education expenses, you don't need to report the form 1099-Q on your son's tax return.

[AmeliesUncle]

Maybe I'm wrong, but I seem to recall reading that the program automatically allocated $4000 out for purposes of claiming the American Opportunity Credit, which may be why it is trigger the 1099-Q to be taxable.

However, you said your income is too high to qualify, so *IF* the program is doing that, I'm not sure how to undo that.  But again, I could be completely wrong about that, but that is what is sticking in my head. 

I think that @Hal_Al  is very knowledgeable about this, so perhaps he could give you some ideas.

[Hal_Al]

Yes, there's a glitch in TT. It does not "sense" that you do not qualify for a tuition credit so it allocates expenses to the credit (sometimes $4000 but usually $10,000).

The 1099-Q and the  1098-T are only an informational documents. 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. 

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

If you feel more comfortable having TT produce the work sheet, there are some things you can try:

Go through the education section again. Go through the entire education interview until you reach a screen titled "Your Education Expenses Summary".  Click edit next to the student's name. That should take you to a screen “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.

Instead, in the education interview, you may reach a screen titled "Choosing a larger education Credit". Verify that TT has entered $10,000 (the amount needed to get the maximum LLC) in the box on that page. In your case, change it to 0.

PLAN C.  On the Student Information Worksheet (abbreviated Student Info Wk on the forms list), go to part VI and change line 17 (“Used for credit”) to 4000. Make the change in the first column.  That will automatically change the other columns.

[Hal_Al]

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

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.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him 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 (usually on the student’s return)

Box 1 of the 1099-Q is $5000

Box 2 is $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

**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. Again, you cannot double dip!  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.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit. Most people come out better having the scholarship taxable before the 529 earnings.