Choosing a larger education credit or deduction seems incorrect

[TaxAmateurPro]

I have 2 students in college, neither of whom has taken an education credit in the past.

For 1 student, TurboTax suggests I play around with education deduction/credit amounts, up to $4000, and doing so ends up saving me about $1K.

For the other student, TurboTax doesn't show me the screen.  I played around, and by reducing the amount I say I paid for room and board by $5K, it shows me the screen, and let's me do something similar.  But when I increase the room and board back to the original amount, when I get to where that credit screen was, it says it's no longer beneficial, and it will helpfully reduce the credit to $0, causing my apparent taxes to go up by ~$1K.

How can saying I paid less for education cause me to save money?  Probably unrelated, but I did mistakenly withdraw a few $K extra from a 529 for this student.  But if anything, reducing the reported expenses further should only exacerbate that situation, not save me money.  I think there may be something wrong here.  For that matter, TurboTax never let me enter the 1098-Ts (somehow inheriting them from last year but putting $0 in).  I had to manually find the forms and enter the amounts directly, outside of the interview process.  Very disappointing difficulties this year.

Any suggestions as to how  I can get TurboTax to allow me to file for the credit?  Or explain what is going on?

[Hal_Al]

Room & board is a qualified expense for a 529 distribution, but it is not a qualified expense for either a tuition credit or for tax free scholarships. 

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Qualified Tuition Plans  (QTP 529 Plans)

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by tax free scholarship***

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q (usually on the student’s return)

Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360)

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip!  When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.

 ***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

[TaxAmateurPro]

@Hal_AI, I really appreciate the detailed answer. 

I would love to be able to reserve $4K to claim against the American Opportunity Credit. That is what I was trying to do.  But TurboTax won't let me. 

As an aside, I received the 1099-Q directly, since the tuition money went through me.  So we can ignore all that potential complexity.

I experimented will all sorts of data input sequences.  Ultimately, reducing the room and board expenses allowed me to get to that override screen, and ultimately, save me $1K on my tax bill via the American Opportunity Credit.   Not intuitive and not the way the program should work.

I really don't understand what is going on here, and I hope that TurboTax is generating correct output.  I guess I'm comforted by the fact that if the IRS questions me about it, I can pull out proof of several thousand more dollars in room & board to offset anything they might complain about.

[Hal_Al]

Turbotax can handle this, but you kinda need to know what you're doing (it's not intuitive) Sometimes, It's better  to use a workaround.

Provide all your numbers and I'll try to guide you.

Box 1 of the 1098-T

Box 5 of the 1098-T

Box 1 of the 1099-Q

Box 2 of the 1099-Q

Room & board amounts

Books, computers and other course materials amount

[tkc737]

I need help with this too...for 2018. Thanks

[TaxAmateurPro]

@Hal_AI, here are the numbers:

• 1098-T Box 1: $55212
• 1098-T Box 5: $12700
• 1099-Q Box 1: $64000
• 1099-Q Box 2: $25464
• Room & Board: $15320
• Books: $1250

[Hal_Al · Accepted solution]

Alternate #1

  $71,782 in educational expenses (55212 + 15,320  +1250)

   -$12,700 paid by tax free scholarship

   -$4000 used to claim the American Opportunity credit

 =$55,082  Can be used against the 1099-Q 

Box 1 of the 1099-Q is $64000

Box 2 is $25,464

55082 / 64000 =86% of the earnings are tax free

0.86 x 25464 = 21,916

You have $3548 of taxable income (25,464 - 21,916)

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Alternate #2

$64,000 -  55,082 = $8918.

Your student reports $8918  of scholarship as income on his tax return. 

  $71,782 in educational expenses(including room & board)

   -$3,782 paid by tax free scholarship (12,700 -8918)

   -$4000 used to claim the American Opportunity credit (AOC)

 =$64,000 Can be used against the 1099-Q (none of the 1099-Q is taxable)

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Assuming alt #2 is best*

You do not enter the 1099-Q at all. You enter the 1098-T on your return and TT will give your the AOC. Do not enter any other educational amounts. 

On your student's return, at the 1098-T screen, you enter  $8918 in box 5 and 0 in box 1**. Do not enter any other educational amounts. This assumes you student even needs to file a tax return.  If the scholarship is his only income, he does not need to file at all (it's less than $12,200).  But, I would have him file just to document it. 

*Which is best will depend on your tax bracket and how much (and type of) other income you student has.  generally, if your student has less than $3082 of other earned income, he will owe no tax.

**The 1098-T is only an informational document. The actual  numbers on it are not required to be entered onto your tax return.  Using the 1098-T screen just simplifies entry in TurboTax.

[TaxAmateurPro]

@Hal_AI, thanks for all your help.  Some very interesting tax-avoidance strategies!

I'm going to mark your answer as done, but FYI I do not think I can avoid entering the 1099-Q on my return since, as I stated earlier, that is addressed to me personally, and the funds went through my account.  I don't think this matters, though: I think your main point was to move some of the scholarship over to the student's return.  Brilliant!

FYI, TurboTax does offer an option built-in to the interview to designate some of scholarship for non-educational purposes, which effectively accomplishes your advice.

FYI, I did this (via reducing the 1098-T Box 5, and again using the TT scholarship reduction), and the tax refund generated by TurboTax matched the same amount as when I reduced the reported room & board expenses.  I still think there is something strange going on in TurboTax, but one way or another, I am able to maximize my refund.  Thanks!