Are Distributions Taxable(p55)

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).

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 2008. 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 February 2, 2009.

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.

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.

Use the following steps to figure the taxable part.

1. Multiply the total distributed earnings shown in box 2 of Form 1099-Q 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.
2. 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 or Form 1040NR, line 21.

In 2002, 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 2008, Sara enrolled in college and had $6,700 of qualified education expenses for the rest of the year. She paid her college expenses from the following sources.

	Partial tuition scholarship (tax-free)	$3,100
	QTP distribution	3,700

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	$6,700
	Minus: Tax-free educational assistance	−3,100
	Equals: Adjusted qualified  education expenses (AQEE)	$3,600

Since the remaining expenses ($3,600) 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)	×	$3,600 AQEE   $3,700 distribution
		= $1,168 (tax-free earnings)

	2.	$1,200 (earnings) − $1,168 (tax-free earnings)
		= $32 (taxable earnings)

Sara must include $32 in income (Form 1040, line 21) as distributed QTP earnings not used for adjusted qualified education expenses.

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.

Assume the same facts as in Example 1, except that Sara's parents claimed a Hope credit of $1,800 (based on $2,400 expenses).

	Total qualified education expenses	$6,700
	Minus: Tax-free educational assistance	−3,100
	Minus: Expenses taken into account  in figuring Hope credit	−2,400
	Equals: Adjusted qualified  education expenses (AQEE)	$1,200

The taxable part of the distribution is figured as follows.

	1.	$1,200 (earnings)	×	$1,200 AQEE   $3,700 distribution
		= $389 (tax-free earnings)

	2.	$1,200 (earnings) − $389 (tax-free earnings)
		= $811 (taxable earnings)

Sara must include $811 in income (Form 1040, line 21). This represents distributed earnings not used for adjusted qualified education expenses.

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.

Assume the same facts as in Example 2, except that instead of receiving a $3,700 distribution from her QTP, Sara received $3,000 from that account and $700 from her Coverdell ESA. In this case, Sara must allocate her $1,200 of adjusted qualified higher education expenses (AQHEE) between the two distributions.

$1,200 AQHEE

×

$700 ESA distribution  $3,700 total distribution

=

$227 AQHEE (ESA)

$1,200 AQHEE

×

$3,000 QTP distribution $3,700 total distribution

=

$973 AQHEE (QTP)

Sara then figures the taxable portion of her Coverdell ESA distribution based on qualified higher education expenses of $227, and the taxable portion of her QTP distribution based on the other $973.

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 23 (Schedule A (Form 1040NR), line 11), 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.

In 2008, 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.

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 2008 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 2008 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.

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

The 10% additional tax does not apply to distributions:

1. Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
2. 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.
3. 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.
4. 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 section 2005(e)(3) of title 10 of the U.S. Code) attributable to such attendance.
5. Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime learning credit (see Coordination With Hope and Lifetime Learning Credits, earlier.

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

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, or Form 1040NR, line 54.