When 529 plan funds are used to pay for qualified education expenses there is usually nothing to report on your federal income tax return. Form 1099-Q and Form 1098-T will list the amount of the 529 plan distribution and how much was used to pay for college tuition and fees, but it is up to the 529 plan account owner to calculate the taxable portion.
What is IRS Form 1099-Q?
IRS Form 1099-Q is a statement issued by a 529 plan or Coverdell ESA administrator that lists the amount of distributions in a given tax year. The Form 1099-Q will be issued to the beneficiary if the 529 distribution was paid to:
- The 529 plan beneficiary
- The college or K-12 school the beneficiary attends
When the Form 1099-Q is issued to the 529 plan beneficiary, any taxable amount of the distribution will be reported on the beneficiary’s income tax return. This typically results in a lower tax obligation than if the Form 1099-Q is issued to the parent or 529 plan account owner.
Form 1099-Q lists the total distributions from a 529 plan or Coverdell ESA during a given tax year, regardless of how the funds were spent. Typically, Box 1 of a Form 1099-Q lists the total distribution, Box 2 includes the earnings portion of the distribution and Box 3 includes the basis, which is the contribution portion of the distribution.
The earnings portion of a non-qualified 529 plan distribution is subject to income tax and a 10% penalty.
What is IRS Form 1098-T?
IRS Form 1098-T is a statement issued by a college or other eligible post-secondary education institution that lists the amount a student paid in tuition, fees required for enrollment or course materials required for enrollment. Form 1098-T is used to determine whether or not the student qualifies for federal education tax credits, such as the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC).
Form 1098-T can be misleading because it does not provide a complete list of 529 plan qualified expenses. For example, Form 1098-T does not include room and board costs, computers and internet access or K-12 tuition. It’s up to the beneficiary and their parents to save receipts and calculate the total amount of qualified 529 plan expenses during the tax year.
How to calculate 529 plan taxable distributions
529 plan distributions used to pay for non-qualified expenses are subject to income tax and a 10% penalty on the earnings portion of the withdrawal. This includes 529 distributions used to pay for airfare and other travel costs, college application or testing fees, health insurance, student loan payments or room and board costs beyond the college’s cost of attendance (COA) allowance.
If the student’s parent qualifies for the AOTC or LLTC, they must adjust their total qualified higher education expenses to avoid double-dipping. To determine the amount of a qualified 529 plan distribution, any amount used to generate the federal education tax credit must be subtracted from the total qualified expenses.
If the beneficiary receives a tax-free scholarship, fellowship grant, Veteran’s educational assistance, employer-provided assistance or other tax-free educational assistance, the amount of the payment must also be subtracted from the total qualified expenses.
For example, parents who claim the AOTC and spend $10,000 on qualified higher education expenses in a given tax year may withdraw $6,000 from a 529 plan without tax consequences:
$10,000 - $4,000 (used to generate the AOTC) = $6,000 Adjusted Qualified Education Expenses (AQEE)
If the student receives a $2,000 tax-free scholarship, the AQEE for the student in this example is reduced further, to $4,000.
Exceptions to the 10% penalty
When the total 529 plan distribution is greater than the AQEE, the amount of the excess will be subject to income tax on the earnings portion of the withdrawal. However, the 10% penalty is waived when the non-qualified distribution occurs as a result of the tax credit adjustment, up to the amount of the qualified expenses that justified the tax credit.
Similar exceptions to the 10% tax penalty apply when the beneficiary receives a tax-free scholarship, veterans’ educational assistance, employer-paid educational assistance and other tax-free educational assistance (other than gifts or inheritances). As with the AOTC and LLTC, the tax penalty is waived only to the extent of the qualified expenses that justified the tax-free educational assistance.
There are also exceptions when the beneficiary dies, is disabled or attends a U.S. military academy.
How to report a taxable 529 plan distribution on federal income tax returns
The earnings portion of a taxable 529 plan distribution must be reported on the beneficiary’s or the 529 plan account owner’s tax returns. To calculate the taxable portion of the 529 plan distribution:
- Divide the AQEE by the total 529 plan distribution (Form 1099-Q, Box 1)
- Multiply the answer by the earnings portion of the total distribution (Form 1099-Q, Box 2).
- Subtract this amount from the total distributed earnings
The result must be reported as income on the beneficiary’s or the account owner’s federal income tax return, Schedule 1 (Form 1040) or Form 1040NR, line 21. If the distribution is subject to the 10% penalty tax, the additional tax must be reported on Schedule 4 (Form 1040), line 59, or Form 1040NR, line 57.