Coordinating AOTC and 529 with low qualified expenses/taxable scholarships?

[Majk_Mom]

With only one semester and generous scholarships in 2023, my college freshman has few qualified expenses. So I’ve been confused about 1) if we can take the American Opportunity Tax Credit (AOTC) with our 529 distribution (part non-qualified), 2) if we can use the IRS “workaround” of reporting scholarships as student income to increase the credit, and 3) if all this is moot because some of the scholarship is taxable (triggering kiddie tax?) – or we just don’t have enough expenses.

Re: “qualified educational expenses.” IRS Pub. 970 says only tuition, fees and books/supplies are QEE. In prior threads, @Hal_AI included Room & Board in “total” qualified expenses when reconciling 529 expenses with IRS/AOTC-qualified expenses, which gives me hope. But if we count only IRS-expenses less scholarships, we’re in negative territory. (No expenses for the credit.)

total QEE:                    $12,510   (tuition, fees, R&B, books less $300 credit)

less scholarships:       -$ 9,567   ($4,895 tuition only; $4,672 “unrestricted”)

we paid:                        $ 2,943    (Direct bill: $2,159 + $784.43 books/supplies)

less AOTC QEE:         -$ 1,574*  (actual expenses: $790 fees + $784.43 books) 

Equals:                        $   1,369 against 1099-Q/Room & Board ($6,341)

Is $1,574 the max AOTC we can claim? Our 529 distribution of $4,000 (paid to student) had earnings of $106.39, so the tax on that is tiny. ($69.98 taxable earnings; no federal and 1% state tax = $.70)

However, if I use only tuition, fees + books, then I get $6,469.43 QEE ($6,169.43 after $300 credit), and after subtracting scholarships ($9,567), our AQEE is – $3,397.57. So is $3,398 in scholarships taxable to our student?? Does this void all attempts at claiming AOTC and trigger kiddie tax?

Can we still claim $2,943 in 529 AQEE against our $4,000 distribution? If so, my rough calcs are:

$2,935 (student earned income) + $3,398 (taxable schol./unearned?) + $27.75 (529 earnings/unearned) = $6,360.75 total income – $3,335 dependent deduction = $3,025.75 taxable income ( >$2,500 = Kiddie tax??)

So there’s no way to report any scholarship as income to increase QEE or decrease tax on scholarships? ($4,672 unrestricted scholarship – $3,398 taxable = $1,274 tax-free, reportable scholarship?)

Final note: 1098-T Box 1 = $10,526 (actual bill: $12,026) and Box 5 = $9,567. Assuming our total scholarships ($9,587) are still not tax-free? Must I enter 1098-T on our return, and the 1099-Q on my student’s?

I’m sorry, this is a lot. Any help is greatly appreciated!

[Hal_Al]

You are basically  allowed to allocate expenses anyway you want, allowing for the restricted scholarship.  So first you allocate $4000 to the AOTC, for the maximum $2500 credit. 

Taxable scholarship is treated as earned income for purposes of a dependent's standard deduction, so none of it will get taxed ($2,935 + $3,398 + 400 = $6733 standard deduction, using your numbers).

The taxable portion of the 529 is so little that it won't get taxed (my quick calc, says none of it is taxable)

Basically, he doesn't need to file a tax return, but you may want to just to document the reporting of taxable scholarship (to free up tuition for the AOTC).

The parents claim $4000 of tuition  on their return to get the  max AOTC.  For simplicity, enter the 1098-T with $4000 in box 1 and box 5 blank.  The 1098-T that you enter in TT is not sent to the IRS.

That's the basics. I may crunch the numbers later for specifics, which you shouldn't really need. 

[Hal_Al]

Allocate the $6341 room and board to the $4000 529 plan  distribution. None of the 1099-Q is taxable. You have $2341 R&B not allocated.  But R&B is not a QEE for anything else (scholarship or credit).

$10,526 in box 1 of the 1098-T minus $4895 restricted scholarship = $5631 available Tuition expense.  Use $4000 for the AOTC.  That leaves $1631 tuition not yet allocated.

$1631 + $784 books = $2415 QEE for the scholarship. $9567 Sch – 4895 restricted tuition – 2415 additional QEE = $2257 taxable scholarship.

[Majk_Mom]

Many thanks for the help, @Hal_Al . This all looks great, but I’m still not tracking with you 100%.

I understand shifting expenses between buckets (529, AOTC, etc.) but struggle with how we can use or allocate expenses charged vs. the actual expenses we paid.

I know we have some leeway since we’re paying tax on the scholarships that covered those billed expenses, but it’s not fully syncing in my brain.

– We can claim $4,000 in AOTC expenses, even though we ourselves only paid $2,943 in total expenses, only $1,574 of which were QEE?

– We paid only $1,369 of the $6,341 charged for room and board, but we can still allocate the full $6,341 charge to our $4,000 (529) distribution?

– Re: “$5,361 available tuition expense” – If our $4,895 restricted scholarship covers 100% of the actual tuition charge (with only $790 fees + $784 books in QEE remaining) can we really treat $1,631 as tuition/QEE?

– The 1098-T Box 1 total shows payments made on our student’s behalf (including non-qualified R&B) rather than payments we ourselves made. But it’s okay to use that $10,526 as qualified expenses any way we need to, so long as the equation balances?

– We can do all this because we’re being taxed on scholarships, which is akin to shifting scholarship dollars to earned income (and increasing our QEE)? And because of the way the college has chosen to report “paid expenses”?

IRS Pub. 970, pg. 16, says: “Finally, the amount of the scholarship or fellowship grant that is applied to non-qualified expenses can't exceed the amount of the student's actual non-qualified expenses that are paid in the tax year.”

I took that to mean that we only had $1,369 in non-qualified expenses paid to play with.

Am I being too literal?

Again, thanks.  

[Hal_Al]

"we paid" doesn't matter. Only "paid", whether paid by you ("we"), the 529 plan, scholarships, loans or the student,  friends or relatives.  The restricted scholarship does matter. 

Q. We can claim $4,000 in AOTC expenses, even though we ourselves only paid $2,943 in total expenses, only $1,574 of which were QEE?

A. Yes.  $4,000+ of tuition was paid (in addition to the $4895 paid by the restricted scholarship). So, that's $4000 that can be allocated to the AOTC and unallocated from the tax free scholarship. 

Q. We paid only $1,369 of the $6,341 charged for room and board, but we can still allocate the full $6,341 charge to our $4,000 (529) distribution?

A. Yes.  Again, it doesn't matter how it was paid, just that it was paid. You're only allocating $4000 of the R&B to the 529 distribution. The other $2341 isn't allocated anywhere.

Q. – Re: “$5,361 available tuition expense” – If our $4,895 restricted scholarship covers 100% of the actual tuition charge (with only $790 fees + $784 books in QEE remaining) can we really treat $1,631 as tuition/QEE?

A. I'm not following those numbers. You said there was $10,526 in box 1 of the 1098-T. Box 1 only contains tuition and qualified fees.  It is not supposed to contain any R&B. That's why I used the whole box 1 amount as QEE. It's possible that the school made a mistake and included R&B in box 1, but it extremely unlikely (schools made that mistake in the early days of the 1098-T, not so much anymore). 

Q.  But it’s okay to use that $10,526 as qualified expenses any way we need to, so long as the equation balances?

A. Yes, unless you absolutely, positively know that number is wrong. 

Q.  But it’s okay to use that $10,526 as qualified expenses any way we need to, so long as the equation balances?

A. Yes. And the term "equation balances" is applied very loosely. 

Q. Finally, the amount of the scholarship or fellowship grant that is applied to non-qualified expenses can't exceed the amount of the student's actual non-qualified expenses that are paid in the tax year.

A. That's pretty meaningless. "Non-qualified expenses" can include many things not previously mentioned. Transportation being a prominent example. It certainly includes the $2341 of room & board not already allocated and any other food consumed by the student. 

Q. Am I being too literal?

A. Yes.  The first time I heard that you could claim a tuition credit even with a scholarship, I said that's too stupid to be true. But there it is and everybody's doing it, and the IRS is encouraging it. 

[Majk_Mom]

Thanks for weighing in. I totally get that the IRS "loophole" of using taxable scholarship to increase QEE is real and legit. My hesitation is mostly the 1098-T itself. 

My older kid's 1098-Ts at a private college always showed actual tuition & fees/real QEE paid, but this state school's Box 1 seems to include cost of attendance averages for all (or nearly all) charges "direct billed" by the college, including housing and dining. (Using lower COA numbers than what we paid.) Otherwise, the QEE total without R&B (or books) would only be $5,590. Since the 1098-T covers only one semester, the tuition charge is only $4,895, period. (Per the school's fall bill, COA chart, and named "full tuition" scholarship.) The standard fees per semester are $695, although we paid $790 with orientation fee. 

Our total bill/charges (including R&B) before scholarships and $300 credit = $12,026, and we had $784 in books. Not sure how they arrived at Box 1: $10,526 QEE ($1,500 less than $12,026, but $4,841 more than the actual $5,685 QEE of $4,895 tuition + $790 fees). 

Still not sure how to proceed. To your point, we had lots of non-qualified expenses, including a $4,000 student health insurance premium, but that doesn't count as a 529 expense. 

[Hal_Al]

Forget room and board and COA for R&B.  They are only QEE for the 529 distribution. We already know we have enough to cover the $4000 on the 1099-Q. And any left over are only non-qualified expenses for scholarship or AOTC. 

Forget non-qualify expenses.  Nobody tries to account for that. They just declare the amount of scholarship that needs to be taxable. 

The only tuition paid is $4,895, period. And that's covered by a restricted scholarship. So none of it can be used for the AOTC.  I would go to the effort to verify the restriction before I deprived myself the full AOTC. Restricted scholarships, within a larger lump sum amount, are unusual. 

This means the only expenses you have for the AOTC are fees & books (you can also include a computer). I'm not gonna try to decipher your numbers. You need to decide what that amount is from your own records.  I'd also go to the effort of verifying that box 1, of the 1098-T,  included R&B (that's unusual).

Since we know the amount of expenses, for the AOTC,  is most likely less than the $4000 needed for the maximum AOTC, that means there are no qualified expenses left over for the rest of the scholarship. That means the taxable amount of the scholarship is $4672 (9567 -4895). 

[Majk_Mom]

Thanks @Hal_Al for your last reply and all your help!
A few (late) notes and questions, sorry.

– The 1098-T Box 1 ($10,526) includes fall 2023 and spring 2024 charges! No R&B, as you said. (Spring bill posted Dec. 2023; not paid till Jan. 2024). Can I enter my own numbers (just fall QEE) into the 1098-T?

– The 1098-T only counts $368 of the $790 fees we paid as “mandatory.” Except for health fee, could orientation and campus bus fees count not as AOTC QEE but as 529 AQEE?

Perhaps not helpful THIS year since our $4,000 1099-Q is fully covered by the $4,672 taxable scholarship, but could it matter in future years with higher 529 distributions (not all qualified) and lower scholarships, i.e, more 529 taxable earnings?

– Re: 2023 $4,672 taxable scholarship. When is it earned vs. unearned income – if my student has self-employed earned income of $2,935? (Required to file?)

Is that $4,672 first treated as earned income for a dependent deduction of $8,007? ($2,935 + $4,672 + $400?) So no regular student income tax is due?

$2,935 (earned) + $4,672 tax. sch. (earned) = $7,607 income –  $8007 ($7,607 + $400) = – $400 or no taxable income?

BUT, that $4,672 is still treated as unearned income (> $2,500) for purposes of calculating kiddie tax? So we will owe kiddie tax on $4,672 – or on $4,272 below?

$2,935 (earned) + $4,672 tax. sch. (unearned) = $7,607 income –  $3,335 ($2,935 + $400) = $4,272 taxable income?

Also, I’m confused in future years about how 529 taxable earnings are factored in. Aren’t taxable 529 earnings considered unearned income? (But I’ve read taxable 529 earnings aren’t subject to kiddie tax?)

Using 2024 real and estimated (529) numbers – which is more correct (required to file)?

A) $6,300 (earned income) + $2,000 (taxable scholarship/earned) + $716 (529 taxable earnings/unearned) = $9,016 total income – $8,700 ($8,300 + $400) = $316 child’s taxable income

B) $6,300 (earned income) + $2,716 ($2,000 taxable scholarship + $716 in 529 tax. earnings/both unearned?) = $9,016 total income – $6,700 ($6,300 + $400) = $2,316 child’s taxable income*

*Is kiddie tax due since $2,716 unearned income is > $2,500? Or not – since total taxable income of $2,316 is < $2,500?

Also, if our 19-year-old makes $6,300 in earned income, are they no longer our tax dependent? (No $500 “other dependent” credit?) Does that affect whether kiddie tax is due? Or whether lower dependent deduction is used or full standard deduction ($14,600) in 2024?

Hope I’m getting there. TT will do its own background calculations, but I’m trying to understand how to steer: avoid unexpected tax at year’s end if we use 529 for non-qualified expenses (like $4,500 health insurance premiums, etc.)  Thanks again. 

[Hal_Al · Accepted solution]

Q.  The 1098-T Box 1 ($10,526) includes fall 2023 and spring 2024 charges! No R&B, as you said. (Spring bill posted Dec. 2023; not paid till Jan. 2024). Can I enter my own numbers (just fall QEE) into the 1098-T?

A. Yes.*

Q. The 1098-T only counts $368 of the $790 fees we paid as “mandatory.” Except for health fee, could orientation and campus bus fees count not as AOTC QEE but as529 AQEE?

A. The rule is the fee must be "required for attendance".  Bus fee: no. Orientation fee: probably yes. Health insurance: usually no, but yes if paid to the school and required for attendance.

Q. Could those additional fees matter in future years with higher 529 distributions (not all qualified) and lower scholarships, i.e, more 529 taxable earnings?

A. Yes. 

Q.  Re: 2023 $4,672 taxable scholarship. When is it earned vs. unearned income?

A.  Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement and the dependent standard deduction calculation (earned income + $400).  It is not earned income for the kiddie tax and other purposes (e.g. EIC).  For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.

Q. if my student has self-employed earned income of $2,935? Required to file?

A. Yes. The filing requirement for self employment income is a mere $400 (they want to collect social security & medicare tax). 

Q. $2,935 (earned) + $4,672 tax. sch. (earned) = $7,607 income –  $8007 ($7,607 + $400) = – $400 or no taxable income?

A. Correct. 

Q. BUT, that $4,672 is still treated as unearned income (> $2,500) for purposes of calculating kiddie tax? So we will owe kiddie tax on $4,672 – or on $4,272 below?

A. No. Kiddie tax is an either or calculation (your unearned income or your taxable income). Since there is no taxable income, there us no kiddie tax. Form 8615 will have to be completed to show the either o calculation. TT does that. 

Q.  Aren’t taxable 529 earnings considered unearned income?

A. Yes.

Q. But I’ve read taxable 529 earnings aren’t subject to kiddie tax?

A. Not true. 

Q. Using 2024 real and estimated (529) numbers – which is more correct (required to file)?

A. First one.  Scholarship is earned income for the taxable income/standard deduction calculation.

Q. Also, if our 19-year-old makes $6,300 in earned income, are they no longer our tax dependent?

A. No. There are two types of dependents, "Qualifying Children"(QC) and Other ("Qualifying Relative" in IRS parlance even though they don't have to actually be related). There is no income limit for a QC but there is an age limit, student status, a relationship test and residence test.

Q. Does that affect whether kiddie tax is due? Or whether lower dependent deduction is used or full standard deduction ($14,600) in 2024?

A. Both.  

*The 1098-T is only an informational document. The numbers on it are not required to be entered onto your tax return. However receipt of a 1098-T frequently means you are either eligible for a tuition credit or possibly your student has taxable scholarship income. 

If you claim the tuition credit, you do need to report that you got one or that you qualify for an exception (the TurboTax interview will handle this)

You claim the tuition credit, or report scholarship income, based on your own financial records, not the 1098-T. In the 1098-T screen, click on the link "What if this is not what I paid the school" underneath box 1. You will then be able to enter the actual amounts paid. You will also reach a screen that allows you to adjust the scholarship amount for "amounts not awarded for 2023 expenses".

Or if you find it easier, just change the numbers in boxes 1& 5 to what your records show. The 1098-T that you enter in TT is not sent to the IRS

[Majk_Mom]

A million thanks for going the distance with me. 

One quick follow-up: In the correct 2024 equation (A) where child taxable income = $316, I thought that any amount of taxable income (above dependent deduction but below individual standard deduction) meant that the taxable scholarship then had to be treated as unearned income. Definitely not true? Only if the resulting taxable income is > $2,500 does kiddie tax kick in with taxable scholarship seen as unearned income?

So in this case, the $316 results in no kiddie tax and $0 federal tax (and tiny state tax)? 

[Hal_Al]

Q. Only if the resulting taxable income is > $2,500 does kiddie tax kick in with taxable scholarship seen as unearned income?

A. No exactly. But, effectively yes.

Q. So in this case, the $316 results in no kiddie tax and $0 federal tax (and tiny state tax)? 

A. No.  The $316 is taxable on the federal return, but no kiddie tax. 

$6,300 (earned income) + $2,000 (taxable scholarship/earned) + $716 (529 taxable earnings/unearned) = $9,016 total income – $8,700 ($8,300 + $400) = $316 child’s taxable income

[Majk_Mom]

Got it. Thanks again.