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Why does TurboTax treat distibutions entered from 529 plans (1099-Q) as taxable?

I received a 1099-Q from my daughter's 529 plan.  The distributions were used for qualified educational expenses (and should be state/ federal tax free).  Why does Turbotax treat the distribution as taxable income when I enter in the data from the 1099-Q?
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    It does work.  I entered a 1099-Q with 10,000 in box 1, 2,000 in box 2 and 8,000 in box 3.  I need to have 10,000 in qualified education expenses to make the 2,000 tax free.  I go to Eduction Expenses, and enter a 1098-T with 14,000 in box 2 and say that I actually paid the full amount of 14,000.  When it ask the amount used to calculate education credit I enter 4,000 so I can get the full $2,500 AOC.  That leaves exactly 10,000 in educational expenses to match the distribution amount in box 1 of 1099-Q.  I should not have any taxable income from box 2 of 1099-Q.

    I switched to Forms mode and opened the Student Info Wks (under the Personal Wks of the student) and go to Part VIII - Qualified Tuition Program (Section 529 Plan) and line 8 "Earnings taxable to recipient" is 0.   None of the earnings from the 529 distribution is taxable.  The other lines in that section are 1) 10,000 2) 10.000 3) 10,000 4) 0 5) 2,000 6) 1.0000 7) 2,000 8) 0

    jlk, open the Student Info Wks and determine why line 8 is showing a number other than 0 when you entered educational expense which equal the total amount of the distribution.
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      This last "answer" by vdirjohn doesn’t work. I entered 1099-Q distributions, all of which are qualified distributions and which should therefore be non-taxable whether earnings or principal. I enter educational expenses which equal the total amount of the distributions. And I still get taxable income for earnings reported, which you should not. Vanguard’s 529 office suggested an answer. Don't use turbotax. I've been using it with pretty good results for 20 years. So I would hope TurboTax would just fix the problem. It's not hard to ask whether the distributions were qualified or not.
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        Thanks for the reply. I checked the worksheet per your suggestion. The reason why the program generates taxable income is this: When one enters $4000 to use the credit, TTax subtracts that amount from total qualified educational expenses to generate an amount called Adjusted Qualified Expenses and then Qualified Education Expenses applied to the QTP that can be less than the amount on the 1098-T, which only includes tuition expenses. TurboTax treats any difference between this adjusted amount and what is on the 1099-Q as an excess distribution which is then taxable income in a proportion related to the percentage of "excess" distributions that reflect earnings rather than principal.

        That's a mouthful, but it is exactly how it works with real numbers, at least when total distributions -- all of which are qualified - exceed the 1098-T amount by enough.

        Your hypothetical example generated no taxable income because you posited 1099-Q distributions as $4,000 less than 1098-T expenses. (Coincidence?) So when $4,000 was subtracted from your 14,000 1098-T, it left $10,000, the same amount as the 1099-Q. In most cases, the expenses minus $4,000 will be less than 1099-Q, generating taxable income. I wonder if that is why the program (for unexplained reasons) gives an option to manually adjust the amount of qualified higher education expenses applied to QTP distributions on Line 3.
        • This is an edited comment because I originally wrote 1098-T on line 4 when I should have written 1099-Q.

          Thanks for the reply. I checked the worksheet per your suggestion. The reason why the program generates taxable income is this: When one enters $4000 to use the credit, TTax subtracts that amount from total qualified educational expenses to generate an amount called Adjusted Qualified Expenses and then Qualified Education Expenses applied to the QTP that can be less than the amount on the 1098-T, which only includes tuition expenses. TurboTax treats any difference between this adjusted amount and what is on the 1099-Q as an excess distribution which is then taxable income in a proportion related to the percentage of "excess" distributions that reflect earnings rather than principal.

          That's a mouthful, but it is exactly how it works with real numbers, at least when total distributions -- all of which are qualified - exceed the 1098-T amount by enough.

          Your hypothetical example generated no taxable income because you posited 1099-Q distributions as $4,000 less than 1098-T expenses. (Coincidence?) So when $4,000 was subtracted from your 14,000 1098-T, it left $10,000, the same amount as the 1099-Q. In most cases, the expenses minus $4,000 will be less than 1099-Q, generating taxable income. I wonder if that is why the program (for unexplained reasons) gives an option to manually adjust the amount of qualified higher education expenses applied to QTP distributions on Line 3.
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        Once you enter the 1099-Q and specify the type of distribution, you will be told to visit the education section of program to enter the education expenses.  Until you do that, box 2 of the 1099-Q is considered taxable income.
        • I had the same problem.  After you enter the 1099-Q, and the 1098-T, there's a screen that asks "Amount used to Calculate Education Deduction or Credit".  Don't enter the amounts from the 1098-T (qualified education expense).  If the amount you enter here plus the 529 distribution amount exceeds the qualified expense, the difference is taxable.  If your daughter is claimed on your return as a dependent, enter zero here.  Your daughter won't qualify for any Education Deduction or Credit because she can be claimed on your return.  This fixed my son's return.
        • I'm having the same problem as Slave1. I still think there is a bug in the program. My qualified expenses were entered as equal to my 1099-q distributions. I also entered this same amount as the amount to use in calculating my deduction/credit at the page mentioned by previous responder but the box2 earnings from the 1099-q are being taxed as other income.
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        Let me try and explain.  The amount of tax credits that the AOC provides and how much of the 529 distribution is tax fee are all based on the amount of qualified education expenses paid in 2010.  You normally want to use the least amount of qualified education expenses needed to get the maximum tax credit and then use the remaining qualified education expenses to make all or most of the 529 distribution tax free.  

        The 1099-Q (529 plan Distribution) shows the amount of the total distribution (box 1), the amount of earnings (box 2) and the amount of the basis (box 3).  Box 1 = Box 2 + Box 3.  Box 3 are your contributions that you have already paid taxes on.  Box 2 is the earnings on those contributions and are considered taxable unless you have enough qualified education expeneses to make them tax free.  Box 1 is the amount of qualified education expenses that you must have to make the entire earnings (box 2 ) tax free.  If you have less than the box 1 amount in qualified education expenses, then a percentage of box 2 will be added to your taxable income.  Enter the 1099-Q under: Income / Less Common Income / Miscellaneous Income.

        You enter all of your qualified education expenses under: Deductions & Credits / Education / Education Expenses.  Qualified Education Expenses for the Education Credits (American Opportunity & Lifetime Learning) are tuiton, fees, course related books, supplies, and equipment.  The tuition and fees normally come from the 1098-T received from your school.  The books, supplies and equipment come from your records of purchases.  Add all of the these expenses together (irregardless of how they were paid - out of pocket , loans, scholarships, grants, fellowships, 529 distributions, Series EE savings bonds) and you have the total amount of qualified education expenses paid in 2010.  

        Now you start using those qualified education expenses to get the best tax return possible.  First, any of those expense that were paid thru financial aid (scholarships, grants, fellowships) are removed.  You cannot get a education credit for expense not paid with your own money.  What you have left is qualified education expenses paid out of pocket, loans, 529 distributions and Series EE savings bonds.  Next you want to use the minimum expenses to get the maximum education credit.  The AOC will give you a $2,500 credit for only $4,000 in expenses.  Therefore you have decreased you qualified education expenses by $4,000.  Whatever amount you actually use, that is the answer to the question "Amount used to Calculate Education Deduction or Credit".  TurboTax will know that that amount cannot be used to clear a 529 distribution.

        Now we are ready to make as much of the earnings (box 2) from the 529 distribution as tax free as possible.  What is nice is that there are now additional college expenses that can be included in the qualified educaiton expenses that are not available for the education credits.  These are Room & Board, Computer, Software and Internet Service and Special Needs Expenses.  Add all of these together and if the amount is equal to or greater than the entire distribution (box 1), then the entire earnings (box 2) is tax free.  If less, the taxable percentage of the earnings is added as income to line 21 (Form 1040) of the beneficiaries tax return.
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