Scholarships and Qualified Tuition Programs

What if my student receives a scholarship and has a prepaid college plan or 529?

Last week, we reviewed whether a scholarship is taxable income.  But what if your student receives a scholarship and has a qualified tuition program?

If your student has a prepaid college plan, 529 plan, or other type of qualified tuition program (“QTP”), the part of the distribution that represents earnings could be taxable if it exceeds the amount of qualified education expenses incurred.

Qualified education expenses for a QTP are different than the test for a scholarship alone.  They still include tuition, fees, books, supplies, and equipment, but also include expenses for room and board and the purchase of computer or peripheral equipment, computer software, and internet access.  Expenses for room and board cannot be excessive and qualify only to the extent that it doesn’t exceed the allowance for room and board as determined by the school that was included in the cost of attendance for federal financial aid purposes or the actual amount charged if the student is residing in housing owned or operated by the school.

To determine if the 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 (“AQEE”).  This is the total qualified education expenses reduced by any tax-free educational assistance, such as the tax-free part of scholarships.

To determine the taxable portion of QTP earnings, you will need to:

1. Multiply the total distributed earnings shown on Form 1099-Q, box 2, by a fraction. The numerator (top part) is the adjusted qualified education expenses paid during the year and the denominator (bottom part) is the total amount distributed during the year.
2. Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Schedule 1 of Form 1040, line 8.

The IRS provides the following example:

In 2011, 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 2019, Sara enrolled in college and had $8,300 of qualified education expenses for the rest of the year. She paid her college expenses from the following sources.

$1,600  Gift from parents

$3,100  Partial tuition scholarship (tax free)

$5,300  QTP distribution

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.

$8,300  Total qualified education expenses                                  

- 3,100  Minus: Tax-free educational assistance

$5,200  Equals: Adjusted qualified education expenses (AQEE)

Since the remaining expenses ($5,200) are less than the QTP distribution, part of the earnings will be taxable.

Sara's Form 1099-Q shows that $950 of the QTP distribution is earnings. Sara figures the taxable part of the distributed earnings as follows.

1.  $950 (earnings) × $5,200 AQEE

                                  $5,300 distribution

      = $932 (tax-free earnings)

2. $950 (earnings) − $932 (tax-free earnings) = $18 (taxable earnings) 

Sara must include $18 in income (Form 1040, Schedule 1, line 8) as distributed QTP earnings not used for adjusted qualified education expenses.

It is important to keep good financial records to make sure that you account for all qualified education expenses incurred during the tax year.  Please contact us if you have further questions on the tax ramifications of scholarship and qualified tuition plans.