Tuition insurance payout

Technical topics regarding tax preparation.
#1
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Chicago, IL
Taxpayer's daughter is 19 in 2021 and started college in the fall and paid additional for "tuition insurance" through a third party insurance company (see link below). After paying for the full semester, they withdrew funds from her 529 to cover the expenses. I'm not sure at this time what these numbers are, but for arguments sake let's say it was $10,000 for tuition, $5,000 for room and board, and $129 for the insurance. They then withdrew $15,000 from the 529 to cover costs 100% before 12/32/21.

Sometime in 2021 the daughter withdrew from school under a medical exemption and filed a claim with the insurance company. They received a $10,000 insurance payout directly from the insurance and nothing from the school. This payout was dated 1-14-22 and obviously received in 2022.

I'm wondering how this will all play out over the course of these two years? Since the payout didn't come until 2022 my guess is that it wouldn't affect the 2021 tax returns at all. Although I suppose there could be the position that the insurance claim had been filed in 2021 and the payout was expected. But either way...should this affect the education expenses paid in 2021 at all as it is an insurance payout?

Never heard of this before and it appears to be pretty new. I've been trying to compare this situation to other types of insurance claims (life, personal auto, rental real estate, casualty loss, etc.) and just can't seem to come to a conclusion as to how this may affect one's taxes:

Taxable in the year received if a deduction was allowed in the prior year?
Not taxable in the year received but reduce the amount of AQEE for the 529 distribution?
Not taxable in the year received because it is insurance and the premium was not deducted anywhere?
Possibly a "refund" of prior year 529 expenses allowed to be returned to the 529?

https://www.rewardexpert.com/blog/allianz-tuition-insurance-helping-families-protect-their-higher-education-investment/
 

#2
Posts:
1362
Joined:
22-Apr-2014 9:07am
Location:
Chicago, IL
Has anyone else encountered anything like this or have any input on it?

We have now received a Form 1098-T for 2022 from the insurance company with $10,000 in Box 10. No money was recontributed to the 529 and no education credit was taken in 2021.

So what I am left with is approximately $15,000 of AQEE paid in 2021, $15,000 distribution from a 529 in 2021 (with about $4,000 of earnings and $11,000 of basis), and then a tuition insurance payout of $10,000 in 2022.

I'm leaning towards amending the 2021 tax return to show that there was only $5,000 of net AQEE after the insurance payout which would make about $2,666 of the 529 distribution taxable in 2021 and also subject to early withdrawal penalty (5,000 AQEE/15,000 dist. = 1/3 x 4,000 earnings = 2,666).

OR maybe should the 10,000 received in 2022 be considered a 2022 distribution and show that 2,666 of it is taxable in 2022?
 


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