I need help understanding the tax ramification of taking a taxable distribution from a 529 plan due to scholarships.
It appears that Publication 970 says that you can take a distribution equal to tax free part of scholarships without being subject to the 10% penalty.
My confusion is:
Do Pell grants and University grant classify as scholarships?
What about the part of scholarship made taxable to allow for the American Opportunity tax credit? Publication 970 appears to indicate you can add that back in.
Can you take distributions for prior tax years? I know that this not allow for regular distributions for QEE expenses.
Would this be correct:
Penalty free distribution (except for taxes on earnings)= Tax Free scholarships + part of scholarship made taxable for AOC
Scholarships, grants, or other educational assistance can be used to offset the 529 10% additional tax to the extent that these funds are not included in taxable income.
There is no formal IRS guidance on this, but the general consensus is that the scholarship/grant and the penalty free 529 distribution do not need to happen in the same tax year.
That would not be correct.
*The 10% additional tax doesn’t apply to the following distributions.
Included in income because the designated beneficiary received:
a. A **tax-free** scholarship or fellowship grant (see Tax-Free Scholarships and Fellowship Grants in chapter 1);
b. Veterans' educational assistance (see Veterans' Benefits in chapter 1);
c. Employer-provided educational assistance (see chapter 11); or
d. Any other **nontaxable (tax-free)** payments (other than gifts or inheritances) received as educational assistance.*
@BelknapPoint, Thank you. What wasn’t clear to me was the following exception:
Included in income only because the qualified education expenses were taken into account in determining
the American opportunity or lifetime learning credit.
In my case, I declare part of the tax free scholarship as taxable in order to claim the AOC. So based on what you wrote, that portion cannot be used as an exception. Makes sense because that would seem to be double dipping.
In this context, “included in income” is referring to the earnings portion of a 529 distribution that would otherwise not be taxable; it is not referring to scholarships or grants.
So the exemption applies to the case where the 529 distribution is used to pay for QEE that were used for the AOC then the earnings would be exempt from the penalty. In which case, the earning would still be taxable?
So in exchange for allowing people to declare part of the scholarship as taxable for the AOC, you lose the penalty exemption for that portion. Makes sense.