AOTC and 529 w/d basis portion

[MNski]

My son is NOT my dependent and NOT a qualifying relative (due to his age/income and not being a FT student).  He was a half-time student his final spring semester and he got a 1098-T for $5,000.  This is the first year he has not been my dependent so there are new wrinkles.

I took a 529 w/d for the exact amount of his tuition plus qualified educ expenses that I paid ($13,000), so the full 529 w/d is non-taxable to me.  The basis portion (non-taxable because it is not earnings) of the w/d was $6,000.  (He is the beneficiary of the 529.  He has no scholarships.)

Can he  take the American Opportunity Tax Credit (AOTC), (subject to the $4k limit and any other adjustments made by TT based on his income etc) ?  

I am thinking because the $5k Basis portion of the 529 withdrawal is greater than his $4k AOTC limit, his AOTC eligibility should not be hindered by the 529 w/d on my return?  (Since there is no "double dipping", correct?  Meaning, I received no tax reduction on the $5K basis portion.)

[MNski]

just to clairfy:  the last paragraph should read 6K basis portion of the 529 w/d, not 5K basis portion.  (5K was the 1098-T tuition).  

[Hal_Al]

Q.  Is the $6000 basis portion of the 529 distribution non-taxable because it is not earnings?

A. Yes, but it is not "deducted off the top". The taxable portion of the earnings is determined by a ratio of the non qualified portion of the distribution, if any, to the total distribution. 

Q. Can he  take the American Opportunity Tax Credit (AOTC)?

A. Yes, but the qualified portion of the 529 distribution will be reduced by the amount of expenses (most likely $4000) used to claim the AOTC, making part of the distribution (w/d) taxable on your return. 

Q. I am thinking because the $6k Basis portion of the 529 withdrawal is greater than his $4k AOTC limit, his AOTC eligibility should not be hindered by the 529 w/d on my return?  (Since there is no "double dipping", correct? 

A. No. The simple explanation is: it doesn't work that way.  See the math below. There is double dipping.  But, you two get to decide how to allocate the expenses between you for the best outcome (him using $4000 for the AOTC is almost always the best way to go). 

  $13,000* in educational expenses (including room & board). 

   -$4000 used to claim the American Opportunity credit on student's return

 =$9000  expenses Can be used against the 1099-Q (on your return)

Box 1 of the 1099-Q is $13,000

Box 2  (earnings) is $7000

9000/13000=69.23% of the distribution is qualified, so 30.77%  is non qualified. This means 30.77% of the earnings are taxable

30.77% x 7000= $2154. There is  $2154 of taxable income on your (the recipient of the distribution) return.

Multiply that  by your marginal tax rate (e.g. 12% x 2154 = $258 in tax) to compare to the $2500 AOTC your son (probably) gets. 

* It wasn't clear whether your total expenses are $13,000 or $18,000.   You taxable income will be a little more with an $18K distribution. 

[NCperson]

@Hal_Al as always, I enjoy and appreciate your analysis.  How can the expenses (the $4000) be allocated? Parent can't take AOTC because student is not a dependent, right? 

@MNski also, son can only take AOTC if it was not used in 4 of the prior years.  it is possible, since he was a student for the spring semester of 2025, you used all four years of eligibility for his fall freshman year (2021) and then 2022, 2023, 2024, which means there is no 2025 eligiblity.  

[Hal_Al]

@NCperson  My assumption was that the student qualified on his own, for the AOTC and even if ineligible for the refundable portion, had enough tax liability to get the non refundable portion.  Good catch on the 4 times limit. The family should still come out better if he can only claim the Lifetime Learning Credit (LLC) but nowhere near as lucratively as the AOTC (I didn't do the actual math). 

[MNski]

Thank you very much!  I do have another question (below, after further explanation).

Clarification:  yes this is the first year he is eligible for the AOTC because he is not my dependent (23 and only a half time student).  The AOTC saves him a whopping $2500 in tax credits ($1500 non refundable plus $1000 refundable).  So he can apply the max $4k AOTC against his $5k in 1098-T tuition.

But, I don't want him to "use" the entire 5k tuition expense because the remaining 1k is of more benefit on my return than his (I am in a higher tax bracket than he is).  On his, if he applies the entire 5k tuition, the earnings portion of the extra 1k just reduces the 10% penalty on an (unrelated) significant 529 withdrawal he took (with no offsetting QHEE, hence the 10% penalty).  (He is done with school and took out the cash that remained in his 529 -- since that was his only income he pays little tax on it and the 10% penalty on the earnings portion seems reasonable.)

My question is the technical process of where to enter (i.e. what forms and line numbers) to account for the amount moving between his and my returns.  I would like him to apply only 4K to the AOTC of the 5K tuition.  Then on my return I will report 4k less in QHEE (somewhere) and TT will calc the earnings portion of that 4k and tax me on that amount.  This tax hit to me will be less than his $2500 AOTC credit so net together we come out ahead.  

Every education expense worksheet seems to have unmodifiable fields in it, so I can't figure out where to subtract the 4K in my return.  I suppose I could edit the 1098-T Tuition paid from 5K to 4K (which is inaccurate as far as what the 1098-T states, but it might force the correct math...?

Thanks again!

[MNski]

OK, I found one field that is editable so I think I found my answer.  If you could please confirm, that would be fab.

Student Info Wks, Part VI, Line 18, Column 1 "Used for Credit":  in both my return and my son's return, I entered 4,000 in that field.  That then populated to remove 4k in QHEE being applied to the 529 w/d I took when I paid his tuition/expenses, and taxed me on the earnings portion of the 4K.  (Should I get hit with a 10% penalty?  TT did not hit me with that, which is perhaps correct since that 4K is QHEE that is just being used on his return for the AOTC?)  On his return, 4,000 entered in that same field reduced the amount being applied to his AOTC to 4k not the full 5K, and his tax adjusted slightly (due to the aforementioned 10% penalty difference on his own directed unrelated 529 non-QHEE withdrawal).  

All good?

[Hal_Al]

If the parent claimed the AOTC 4 times, on his education (which is the usual situation), back when he was your dependent, then he is not eligible for any AOTC now that he is out on his own. He doesn't get an additional 4 AOTCs on his own.  The 4 time limit applies to his  education, not the taxpayer. For example, if the parent only claimed it 3 times, then there is one left for him to claim. 

Assuming that's not your case, here's how you enter it in TurboTax (TT). 

Q. I suppose I could edit the 1098-T Tuition paid from 5K to 4K (which is inaccurate as far as what the 1098-T states, but it might force the correct math...?

A. Yes, that's basically it.*

On the student's return, he enters the 1098-T with $4000 in box 1 and box 5 blank. 

On the parent's return, you enter the 1099-Q and say that the student was  "somebody else".  At the non dependent summary page, you click the edit pencil. That will give you screens to enter your expenses.  You enter only $1000 tuition.  You will not enter a 1098-T, since the student is not your dependent. 

*The 1098-T is only an informational document. The numbers on it are not required to be entered onto his tax return.  If you claim the tuition credit, you do need to report that you got one.

You claim the tuition credit, or report scholarship income, based on your own financial records, not the 1098-T. If you find it easier, just change the numbers in boxes 1& 5 to what your records show. The 1098-T that he enters in TT is not sent to the IRS. It's just an entry tool. 

[Hal_Al]

Yes, making that entry at Student Info Wks, Part VI, Line 18, Column 1 "Used for Credit" is another way to do it.  It  may even be better in that you don't have to "manipulate" the numbers.

Q. Should I get hit with a 10% penalty?  

A. No. TT is doing it correct since that 4K is QHEE that is just being used on his return for the AOTC (a penalty exception). 

[Hal_Al]

<< On his return, 4,000 entered in that same field reduced the amount being applied to his AOTC to 4k not the full 5K, and his tax adjusted slightly (due to the aforementioned 10% penalty difference on his own directed unrelated 529 non-QHEE withdrawal)>>

This seems to be introducing a new issue.  I don't recall  a separate 529 withdrawal being mentioned.  I don't think you can't apply the penalty exception to both your  529 withdrawal and his wthdrawal for the same $4000. 

[MNski]

re: "same" 4k being applied to AOTC and being 529 w/d penalty-free:  on his return, he is paying the tax and 10% penalty on ALL of his unrelated 529 w/d.  (this 4k portion of his 1098-T tuition is only being applied to the AOTC to get the credit but not reducing his unrelated 529 w/d).  so it is not reducing any penalty for him. on my return, I am paying tax but not paying any penalty because the 4k is being allocated to him for the AOTC, and the rest of my 529 w/d has QHEE.  [I guess in theory if I had known before doing my 529 w/d that he might be eligible for the AOTC, I would have made my 529 w/d smaller to not even be taxed on it.]   ...Are you saying I should be hit with a 10% penalty on my return for the 4K going to his AOTC?  I think the penalty-free aspect of the 4k is only being applied once, on MY return - he isn't using it on HIS return to offset any 529 w/d.

note re 4 yr eligibility:  we have never been eligible for any education tax credit before, so this is not an issue.  also, the 4 yr limit says "has completed 4 yrs by Jan 1", which as of 1/1/25 he had not (only 3-1/2), so he is eligible in 2025.  As of each Jan 1:  in 2021 he was only halfway through freshman year, so 2022 was his first year of eligibility for AOTC (when he'd completed 1-1/2 years).  

[AmyC]

Your son qualifies for the AOTC as he was still in school. You get to pay tax on 529 earnings but there is no penalty. The penalty is waived when it is taxable due to claiming the AOTC.

You mentioned he had his own unrelated 529 withdrawal that was non-qualified.

Important: He cannot use the same $4,000 "penalty-free" exception that you are using. The exception follows the expenses. Since you are using that $4,000 of tuition to justify the AOTC and "protect" your withdrawal from the penalty, he must have other qualified expenses or a different exception (like a scholarship) to avoid the penalty on his own withdrawal.

If his withdrawal was truly for non-educational purposes and he has no other expenses, he correctly paid the tax and the 10% penalty on his return.

[MNski]

Thanks, Amy!  (Love "get to" pay tax...)  😂

Yes, his unrelated unqualified 529 withdrawal has no QHEE to offset it.  So he is paying tax (minimal since he has no other income) and the 10% penalty on ALL of that.  So I think that is a non-factor.

The 4K tuition used to claim the credit thus does not appear on his return other than for the express purpose to claim the AOTC.  It is not an expense used to offset a 529 w/d, and as noted previously his 1098-T is informational only.  So the only place the 4K AOTC penalty-exemption is being applied is on MY return, where I am now paying tax on the 4K 529 w/d, but no penalty.  

So if I am reading your response correctly, this is accurate handling of it, with no double-dipping.

[AmyC]

Your son can claim the AOTC thanks to your thoughtful gift of the 529 withdrawal which allowed him to pay tuition. There is no double dipping and you navigated all the factors. You have worked this out beautifully, well done.