taxmap/pubs/p970-038.htm#TXMP631a4325
Are Distributions Taxable

taxmap/pubs/p970-038.htm#TXMP4ebf68f6 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 2006. 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, 2007.

taxmap/pubs/p970-038.htm#TXMP7af67e14 Figuring the Taxable   Portion of a Distribution

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.

taxmap/pubs/p970-038.htm#TXMP0bb8e7a3 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.

taxmap/pubs/p970-038.htm#TXMP4bb16a3d Taxable earnings.

Use the following steps to figure the taxable part.

1. 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.
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, line 21.

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Example.

In 2000, 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 2006, 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 mexpenses	$6,700
	Minus: Tax-free educational assistance	−3,100
	Equals: Adjusted qualified meducation 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)	×	00$3,600 AQEE00 $3,700 distribution
		m=n$1,168 (tax-free earnings)

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

Sara must include $32 in income as distributed QTP earnings not used for adjusted qualified education expenses.

taxmap/pubs/p970-038.htm#TXMP1deeb20c Coordination With Hope and   Lifetime Learning Credits

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.

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Example.

Assume the same facts for Sara Clarke as in the previous example, except that Sara's parents claimed a Hope credit of $1,650.

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

The taxable part of the distribution is figured as follows.

	1.	$1,200 (earnings)	×	00$1,400 AQEE00 $3,700 distribution
		m=n$454 (tax-free earnings)

	2.	$1,200 (earnings)n−n$454 (tax-free earnings)n
		m=n$746 (taxable earnings)
		m

Sara must include $746 in income. This represents distributed earnings not used for adjusted qualified education expenses.

taxmap/pubs/p970-038.htm#TXMP720e4e20 Coordination With Coverdell   ESA Distributions

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.

taxmap/pubs/p970-038.htm#TXMP465b6135
Example.

Assume the same facts as in the last example for Sara Clarke, 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 $1,400 of adjusted qualified higher education expenses (AQHEE) between the two distributions.

$1,400 AQHEE

×

n$700 ESA distributionn $3,700 total distribution

=

$265 AQHEE (ESA)

$1,400 AQHEE

×

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

=

$1,135 AQHEE (QTP)

Sara then figures the taxable portion of her Coverdell ESA distribution based on qualified higher education expenses of $265, and the taxable portion of her QTP distribution based on the other $1,135.

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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.

taxmap/pubs/p970-038.htm#TXMP1537a561 Losses on QTP Investments

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.

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Example 1.

In 2006, 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.

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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 2006 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 2006 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)n−n$4,500 (basis portion of distribution)
		m= $5,500 (earnings included in distribution)

	2.	$5,500 (earnings)	×	00 $6,000 AQEE 00 $10,000 distribution
		m=n$3,300 (tax-free earnings)

	3.	$5,500 (earnings)n−n$3,300 (tax-free earnings)
		mn=n$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.

taxmap/pubs/p970-038.htm#TXMP6406b26e Additional Tax on   Taxable Distributions

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.

taxmap/pubs/p970-038.htm#TXMP43608ee9 Exceptions.

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.
6. 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.

taxmap/pubs/p970-038.htm#TXMP13ba1b1b 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 60.

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