If someone has contributed money to a 529 plan or a Coverdell Education Savings Account (Coverdell ESA) and designates you as the beneficiary, you will receive an IRS Form 1099-Q when you start tapping into those funds. When you receive the 1099-Q each year, it may be necessary to include some of the amounts it reports on your tax return.
Qualified education programs
There are two types of qualified education programs: state-sponsored 529 plans and Coverdell ESAs. Both types of accounts allow the account owner to set aside money to cover the qualified education expenses for the person who is designated as the beneficiary. The tax benefit of both programs is that the IRS allows account contributions to grow tax-free, meaning neither the beneficiary nor the account owner has to pay tax on account earnings.
Beneficiary receives 1099-Q
The person or entity who manages the education program has an obligation to report annual distributions on Form 1099-Q to the IRS and to the beneficiary. However, the account owner (such as a parent) will receive a copy of the 1099-Q instead if the distributions from a 529 plan aren’t made directly to the beneficiary or to an educational institution for the benefit of the beneficiary.
When the beneficiary enrolls in school and starts taking distributions to pay school expenses, he will begin receiving a Form 1099-Q each year. And as long as the distributions are used to pay only qualified education expenses, the beneficiary doesn’t pay income tax on the distributions.
Information reported on 1099-Q
Box 1 of your 1099-Q will report the total distribution from your education program for the year, regardless of whether the funds are sent directly to the school. Box 2 reports the portion of the distribution that represents account earnings, while Box 3 reports the portion representing the original contribution to the account. In other words, the amount reported in Box 3 must equal Box 1 minus Box 2.
In some cases, your 1099-Q may include the fair market value of the account. Boxes 4 through 6 provide additional information, but they have no impact on whether some of your distributions are reportable on a tax return.
Beneficiary tax implications
For most qualified education program beneficiaries, the amounts reported on the 1099-Q aren’t reported on a tax return. However, if annual distributions exceed your adjusted qualified education expenses, you may need to report some of the earnings reported in box 2 as income on your tax return and pay an additional 10 percent tax on it as well. Your adjusted expenses are equal to the total of your qualified education expenses minus other tax-free assistance you receive, such as scholarships and Pell grants. For example, suppose your qualified education expenses are $10,000, you receive a $2,000 Pell grant and boxes 1 and 2 of your 1099-Q report a gross distribution of $8,000 and earnings of $1,000. Your adjusted expenses are $8,000 -- which means you don’t have to report any education program distributions on your tax return.