529 plan distribution less than qualified tuition, why there is taxable amount of the distribution

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March 9, 2021
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My 529 plan distribution is only half of the qualified tuition reported on 1098-T. Turbo tax shows a part of the distribution is taxable. Why?

Hal_Al

Employee

The interview is complicated and it's easy to make mistakes. It's best if you enter the 1099-Q before entering the 1098-T.

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. You also cannot count expenses that were paid by tax free scholarships. 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.

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."

There are three things you can do with your Qualified educational expenses (QEE):

Allocate then to scholarships (so that the scholarship remains tax free)
Use them to claim an education credit
Allocate them to the 529 distribution (1099-Q) so that it will not be taxable

TurboTax allocates QEE, in that order, until you tell it otherwise.

One possibility is that TurboTax allocated part of your dependent's college expenses to claim the Tuition credit, even if you are not eligible or otherwise did not claim it. That reduces the amount that can be used to claim the 529 earnings, shown on the 1099-Q, as being totally tax free. 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. You may reach that screen sooner.

Another possibility is that you had scholarships that TurboTax allocated some of the expenses to. To make the scholarship taxable, you must tell TT how much you want taxable by saying it was used for room &board. Note the wording at that screen “or other expenses”. You didn’t have to literally use the scholarship for R&B.

TurboTax will assign all the available expenses to the tuition credit; then present you with a screen titled “Amount Used to Calculate Education Deduction or Credit” You have to know to change that amount to $4000 (there is an explanation and instructions on that page).

Hal_Al

Employee

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 $600

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

60%x600= $360

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

**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.

***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.