Can I choose to NOT claim my college student child as a dependent, although she is?

[BK2000]

Doing some preliminary year end review, it appears that we come out ahead if I don't claim my full-time college student child as my dependent – for 2023 tax year only. I want to know if this approach is allowed and not subject to any flags.

Me: married filing jointly in California. Daughter: 2nd year undergrad full-time college student attending a California university, not living at home. Her earned income was $2300 from summer jobs, no other investment income. She will have income from 'excess' 529 distributions toward college expenses which she is the beneficiary (excess due to withdrawing for scholarships as well).  Since the 529 has paid for her expenses, she has arguably paid more than half of her own expenses, hence could be considered independent, right?

Why am I exploring this option? I qualify for Fed's EV tax credit of up to $7500 based on the amount of my tax liability of course (which is less than that).
a) If she is my dependent, the AOTC will go into my tax return and I will get very little of the Fed EV tax credit. And she will owe taxes because of the income from the excess 529 distribution. If I increase my capital gains (from investments or Roth conversion), then my State tax liability increases – not an ideal approach.
b) If she is NOT my dependent, the AOTC will go on her tax return (instead of mine) and hence a refund to her, and I will also receive a much bigger EV tax credit. Overall, both of us combined will come out ahead.

So back to the original question: Am I allowed to NOT claim her as my dependent?  Other suggestions?

Caveats and another question:
* Since TurboTax is half baked at the time of this writing where some forms such as EV, 1099-B etc. are not available yet, my calculations and assumptions will be off.
* State: Am I allowed to claim her as my dependent in my State return, even if I didn’t do so in Federal? Will it flag my return? This will impact my State’s tax liability amount.
Using Windows desktop installed TurboTax deluxe. TIA

[Bsch4477 · Accepted solution]

You don’t have to claim a dependent even though a person qualifies you to do so. 

However even if you don’t claim her she would have to say that someone can claim her. That’s because if you own the 529 and she is the beneficiary, you not her, provided that support. That means that she could be your dependent and that makes her ineligible to receive the refundable portion of the AOC. 

Whether she can not be claimed as a dependent on Federal and claimed on the state return varies by each state. 

[Hal_Al · Accepted solution]

Q. Since the 529 has paid for her expenses, she has arguably paid more than half of her own expenses, hence could be considered independent, right?

A. No (more accurately, probably No).  The treatment of expenses paid with distributions from Sec. 529 plans and Coverdell ESAs in the support test is uncertain because of the dual nature of these college savings vehicles and a lack of IRS guidance. The consensus among tax experts is that it is parental support, because the parent is the owner of the plan.  

References: https://www.savingforcollege.com/articles/the-impact-of-529-plans-on-claiming-a-dependent

https://proconnect.intuit.com/community/tax-talk/discussion/529-plan-distribution-and-support-test/0...

Q.  If she is NOT my dependent, the AOTC will go on her tax return (instead of mine) and hence a refund to her. Right?

A. No. A full time unmarried student, under age 24, even if she doesn't qualify as a dependent, is only eligible for the refundable portion of the American Opportunity Credit if she supports herself by working. She cannot be supporting herself on parental support, 529 plans or student loans & grants. It is usually best if the parent claims that credit.  If she has an actual tax liability, she is allowed to claim the non refundable AOTC, up to the full $2500 (the refundable portion switches to non refundable). 

Q.  Am I allowed to NOT claim her as my dependent? 

A.  Yes.  But, she is still not allowed to "claim herself".  In particular, this means no refundable AOTC.  She doesn't automatically  get a full $13,850 standard deduction (2023).  You lose the $500 Other dependent credit. 

Q. Other suggestions?

A. She can declare some/more of her scholarship as taxable, making less of the 529 distribution taxable. Non qualified 529 distributions are unearned income. 

Taxable scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement (2023) and the dependent standard deduction calculation (earned income + $400, up to $13,850).  It is not earned income for the kiddie tax and most other purposes (e.g. AOTC).  

[BK2000]

Thank you both, @Bsch4477 and @Hal_Al 

Your responses are very clear and easily settle my question - Cheers.