Publication 970: Tax Benefits for Education; Chapter 8

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Table of Contents

What's New

Distributions from eligible educational institution QTPs may be tax free. Beginning in 2004, you may not have to include in income a distribution from a QTP established and maintained by an eligible educational institution.

Introduction

States may establish and maintain programs that allow you to either prepay or contribute to an account for paying a student's qualified education expenses (defined later). Eligible educational institutions may establish and maintain programs that allow you to prepay a student's qualified education expenses. If you prepay tuition, the student (designated beneficiary) will be entitled to a waiver or a payment of qualified education expenses. You cannot deduct either payments or contributions to a QTP. For information on a specific QTP, you will need to contact the state agency or eligible educational institution that established and maintains it.

What is the tax benefit of a QTP. No tax is due on a distribution from a QTP unless the amount distributed is greater than the beneficiary's adjusted qualified education expenses. See Are Distributions Taxable, later, for more information.

Even if a QTP is used to finance a student's education, the student or the student's parents still may be eligible to claim either the Hope credit or the lifetime learning credit.

What Is a Qualified Tuition Program

A qualified tuition program (also known as a 529 plan or program) is a program set up to allow you to either prepay, or contribute to an account established for paying, a student's qualified education expenses at an eligible educational institution. QTPs can be established and maintained by states (or agencies or instrumentalities of a state) and eligible educational institutions. The program must meet certain requirements. Your state government or the eligible educational institution in which you are interested can tell you whether or not they participate in a QTP.

Qualified education expenses. These expenses are the tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution (defined in the next column).

They also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student. The cost of room and board qualifies only to the extent that it is not more than the greater of the following two amounts.

The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

You will need to contact the eligible educational institution for qualified room and board costs.

The definition of qualified education expenses was expanded in 2002 to include expenses of a special needs beneficiary that are necessary for that person's enrollment or attendance at an eligible educational institution.

As of this printing, regulations defining a “special needs beneficiary” have not been released. If available, the definition will be included in Publication 553, Highlights of 2004 Tax Changes, which will be issued in early 2005.

Designated beneficiary. The designated beneficiary is generally the student (or future student) for whom the QTP is intended to provide benefits. The designated beneficiary can be changed after participation in the QTP begins. If a state or local government or certain tax-exempt organizations purchase an interest in a QTP as part of a scholarship program, the designated beneficiary is the person who receives the interest as a scholarship.

Eligible educational institution. For purposes of a QTP, this is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

Certain educational institutions located outside the United States also participate in the U.S. Department of Education's Federal Student Aid (FSA) programs. You can find a list of these foreign schools on the Department of Education's website at www.fafsa.ed.gov/index.htm. Click on “Find my school codes.” Complete the two items on the first page and click “Next.” Follow the instructions to search for a foreign school.

How Much Can You Contribute

Contributions to a QTP on behalf of any beneficiary cannot be more than the amount necessary to provide for the qualified education expenses of the beneficiary. There are no income restrictions on the individual contributors.

You can contribute to both a QTP and a Coverdell ESA in the same year for the same designated beneficiary.

Are Distributions Taxable

The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan.

The designated beneficiary generally does not have to include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified education expenses (defined under Figuring the Taxable Portion of a Distribution, below).

Note.

Before 2004, the beneficiary had to include in income any earnings distributed from a QTP established and maintained by an eligible educational institution.

Earnings and return of investment. You will receive a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), from each of the programs from which you received a QTP distribution in 2004. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment, (box 3). Form 1099-Q should be sent to you by January 31, 2005.

Figuring the Taxable Portion of a Distribution

To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.

Adjusted qualified education expenses. This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:

The tax-free part of scholarships and fellowships (see chapter 1),
Veterans' educational assistance (see chapter 1),
Pell grants (see chapter 1),
Employer-provided educational assistance (see chapter 11), and
Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.

Taxable earnings. Use the following steps to figure the taxable part.

Multiply the total distributed earnings shown on Form 1099-Q (box 2) by a fraction. The numerator is the adjusted qualified education expenses paid during the year and the denominator is the total amount distributed during the year.
Subtract the amount figured in (1) from the total distributed earnings. This is the amount the beneficiary must include in income. Report it on Form 1040, line 21.

Example.

In 1998, Sara Clarke's parents opened a savings account for her with a QTP maintained by their state government. Over the years they contributed $18,000 to the account. The total balance in the account was $27,000 on the date the distribution was made. In the summer of 2004, Sara enrolled in college and had $6,500 of qualified education expenses for the rest of the year. She paid her college expenses from the following sources.

	Partial tuition scholarship (tax-free)	$3,000
	QTP distribution	3,600

Before Sara can determine the taxable part of her QTP distribution, she must reduce her total qualified education expenses by any tax-free educational assistance.

	Total qualified education expenses	$6,500
	Minus: Tax-free educational assistance	-3,000
	Equals: Adjusted qualified education expenses (AQEE)	$3,500

Since the remaining expenses ($3,500) are less than the QTP distribution, part of the earnings will be taxable.

Sara's Form 1099-Q shows that $1,200 of the QTP distribution is earnings. Sara figures the taxable part of the distributed earnings as follows.

	1.	$1,200 (earnings)	×	$3,500 AQEE $3,600 distribution
		=$1,167 (tax-free earnings)

	2.	$1,200 (earnings)-$1,167 (tax-free earnings)
		=$33 (taxable earnings)

Sara must include $33 in income as distributed QTP earnings not used for adjusted qualified education expenses.

Coordination With Hope and Lifetime Learning Credits

A Hope or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit.

Example.

Assume the same facts for Sara Clarke as in the previous example, except that Sara's parents claimed a Hope credit of $1,500.

	Total qualified education expenses	$6,500
	Minus: Tax-free educational assistance	-3,000
	Minus: Expenses taken into account in figuring Hope credit	-2,000
	Equals: Adjusted qualified education expenses (AQEE)	$1,500

The taxable part of the distribution is figured as follows.

	1.	$1,200 (earnings)	×	$1,500 AQEE $3,600 distribution
		=$500 (tax-free earnings)

	2.	$1,200 (earnings)-$500 (tax-free earnings)
		=$700 (taxable earnings)

Sara must include $700 in income. This represents distributed earnings not used for adjusted qualified education expenses.

Coordination With Coverdell ESA Distributions

If a designated beneficiary receives distributions from both a QTP and a Coverdell ESA in the same year, and the total of these distributions is more than the beneficiary's adjusted qualified higher education expenses, the expenses must be allocated between the distributions. For purposes of this allocation, disregard any qualified elementary and secondary education expenses.

Example.

Assume the same facts as in the last example for Sara Clarke, except that instead of receiving a $3,600 distribution from her QTP, Sara received $3,000 from that account and $600 from her Coverdell ESA. In this case, Sara must allocate her $1,500 of adjusted qualified higher education expenses (AQHEE) between the two distributions.

$1,500 AQHEE

$600 ESA distribution
$3,600 total distribution

$250
AQHEE (ESA)

$1,500 AQHEE

$3,000 QTP distribution
$3,600 total distribution

$1,250
AQHEE (QTP)

Sara then figures the taxable portion of her Coverdell ESA distribution based on qualified higher education expenses of $250, and the taxable portion of her QTP distribution based on the other $1,250.

Note.

If you are required to allocate your expenses between Coverdell ESA and QTP distributions, and you have adjusted qualified elementary and secondary education expenses, see the examples in chapter 7 under Coordination With Qualified Tuition Program (QTP) Distributions.

Losses on QTP Investments

If you have a loss on your investment in a QTP account, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 22, subject to the 2%-of-adjusted-gross-income limit.

If you have distributions from more than one QTP account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP accounts.

Example 1.

In 2004, Taylor received a final distribution of $1,000 from QTP #1. His unrecovered basis in that account before the distribution was $3,000. If Taylor itemizes his deductions, he can claim the $2,000 loss on Schedule A.

Example 2.

Assume the same facts as in Example 1, except that Taylor also had a distribution of $9,000 from QTP #2, giving him total distributions for 2004 of $10,000. His total basis in these distributions was $4,500—$3,000 for QTP #1 and $1,500 for QTP #2. Taylor's adjusted qualified education expenses for 2004 totaled $6,000. In order to figure his taxable earnings, Taylor combines the two accounts and determines his taxable earnings as follows.

	1.	$10,000 (total distribution)-$4,500 (basis portion of distribution)
		= $5,500 (earnings included in distribution)

	2.	$5,500 (earnings)	×	$6,000 AQEE $10,000 distribution
		=$3,300 (tax-free earnings)

	3.	$5,500 (earnings)-$3,300 (tax-free earnings)
		=$2,200 (taxable earnings)

Taylor must include $2,200 in income on Form 1040, line 21. Because Taylor's accounts must be combined, he cannot deduct his $2,000 loss (QTP #1) on Schedule A. Instead, the $2,000 loss reduces the total earnings that were distributed, thereby reducing his taxable earnings.

Additional Tax on Taxable Distributions

Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.

Exceptions. The 10% additional tax does not apply to distributions:

Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
Included in income because the designated beneficiary received:
1. A tax-free scholarship or fellowship (see chapter 1),
2. Veterans' educational assistance (see chapter 1),
3. Employer-provided educational assistance (see chapter 11), or
4. Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point). This exception applies only to the extent that the amount of the distribution does not exceed the costs of advanced education (as defined in title 10 of the U.S. Code) attributable to such attendance.
Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime learning credit.
Made before 2004 and used for qualified education expenses, but included in income because it was paid from a QTP established and maintained by an eligible educational institution.

Exception (3) applies only to the extent the distribution is not more than the scholarship, allowance, or payment.

Figuring the additional tax. Use Part II of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure any additional tax. Report the amount on Form 1040, line 59.

Rollovers and Other Transfers

Assets can be rolled over or transferred from one QTP to another. In addition, the designated beneficiary can be changed without transferring accounts.

Rollovers

Any amount distributed from a QTP is not taxable if it is rolled over to another QTP for the benefit of the same beneficiary or for the benefit of a member of the beneficiary's family (including the beneficiary's spouse). An amount is rolled over if it is paid to another QTP within 60 days after the date of the distribution.

Members of the beneficiary's family. For these purposes, the beneficiary's family includes the beneficiary's spouse and the following other relatives of the beneficiary.

Son or daughter or descendant of son or daughter.
Stepson or stepdaughter.
Brother, sister, stepbrother, or stepsister.
Father or mother or ancestor of either.
Stepfather or stepmother.
Son or daughter of a brother or sister.
Brother or sister of father or mother.
Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
The spouse of any individual listed above.
First cousin.

Example.

When Aaron graduated from college last year he had $5,000 left in his QTP. He wanted to give this money to his younger brother, who was in junior high school. In order to avoid paying tax on the distribution of the amount remaining in his account, Aaron contributed the same amount to his brother's QTP within 60 days of the distribution.

Only one rollover per QTP is allowed during the 12-month period ending on the date of the payment or distribution.

Changing the Designated Beneficiary

There are no tax consequences if the designated beneficiary of an account is changed to a member of the beneficiary's family (defined above).

Example.

Assume the same situation as in the last example. Instead of closing his QTP and paying the distribution into his brother's QTP, Aaron could have instructed the trustee of his account to simply change the name of the beneficiary on his account to that of his brother.

Chapter 8 - Qualified Tuition Program (QTP)