When taking a distribution from the 529 plan for my son (for non-qualified expenses) in an amount equivalent to his earned scholarship, why do I need to pay taxes on the deduction if I used after-tax dollars when contributing to the 529 plan?
I understand that there is no 10% penalty for this deduction, and I that I should pay taxes on the earnings I have accrued on this investment, but not sure if/how just the earnings portion vs. the full amount of the withdrawal amount is taxed. Is this something I have to estimate or track on my own, based on when my contributions were made, etc.?
Appreciate any help or guidance that can be provided.
@TZ143 why did you take a distribution equal to the scholarship? best if you provide some numbers - will make the explanation easier
1) full cost of education - all expenses
2) what is in Box 1 of form 1098-T. Any other qualified educational expenses not in Box 1?
3) what is in Box 5 of form 1098-T
4) how much did you withdraw from the 529?
Q. I am not sure if/how just the earnings portion vs. the full amount of the withdrawal amount is taxed. Is this something I have to estimate or track on my own, based on when my contributions were made, etc.?
A. The plan administrator does this for you. In January (maybe as late as mid February), you will receive a form 1099-Q. Box 1 will have the total distribution. Box 2 will show the earnings (taxable) portion of the distribution.
You are correct, because of the scholarship, the 10% penalty will not apply.
The education part of the tax code can get a little tricky. Scholarships that pay for Qualified expenses (tuition, fees, course materials) is tax free. Scholarships that pay for room & board is taxable income to the student. Because room and board was not paid by tax free scholarship, the part of the 529 distribution covering room and board is a qualified (tax fee) distribution.
Furthermore, there is a loop hole available to claim a tuition credit, or use a 529 distribution for tuition, by having the student report more of his scholarship, as income. Up to $13,850 (the 2023 standard deduction) of scholarship can effectively go untaxed. As others have suggested, provide more detailed info for more specific advise.
Provide the following info for more specific help:
- Are you the student or parent.
- Is the student the parent's dependent.
- Box 1 of the 1098-T
- box 5 of the 1098-T
- Any other scholarships not shown in box 5
- Does box 5 include any of the 529/ESA plan payments (it should not)
- Is any of the Scholarship restricted; i.e. it must be used for tuition
- Box 1 of the 1099-Q
- Box 2 of the 1099-Q
- Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)?
- Room & board paid. If student lives off campus, what is school's R&B on campus charge. If he lives at home, the school’s R&B “allowance for cost of attendance” for student living with parents.
- Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers
- How much taxable income does the student have, from what sources
- Are you trying to claim the tuition credit (are you eligible)?
- Is the student an undergrad or grad student?
- Is the student a degree candidate attending school half time or more?
Qualified Tuition Plans (QTP 529 Plans) Distributions
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 American Opportunity Credit (AOC or AOTC) is 100% of the first $2000 of tuition and 25% of the next $2000 ($2500 maximum credit). 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.
$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 (on the recipient’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
There is $1120 of taxable income (on the recipient’s 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. 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.
@NCperson : Thank you for the reply. I should have clarified: I have not yet taken the distribution, but I am considering doing it to help pay for other, non-qualified expenses (e.g., housing & food costs above the university's Cost of Attendance). Before I take the distribution, I just wanted to ensure I'd only be taxed on the earnings of my 529 contributions and not the principal, since I contributed using after-tax dollars.
In terms of the amount I can withdraw, I was trying to play it "safe" and simply not withdraw more than the amount equal to my son's scholarship, which should be sufficient to help me cover the additional non-qualified expenses.
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