Declining AOC

[chrisgh]

My son is currently in his  final semester of college.   We have used the AOC for 3 years (2019,20,21).  When I run the 2022 taxes, reporting the 1099Q's (one on his SSN, one on mine), all qualified expenses, scholarships, the Education Credit optimizer says that I can take a $2 AOC credit.   Looking ahead to 2023, he will no longer be our dependent (his final semester is not full time).  Would it make sense for us to decline the $2 AOC for 2022, so that my son has the option to claim his 4th year of AOC against this last semester (tuition after scholarships will be over $5000) on his 2023 taxes ?

[MonikaK1]

In the situation you described, you only have the option not to claim the American Opportunity Credit for 2022 if it is the third year of study and allow your son to take the 4th year of the credit in 2023 when he is no longer a dependent. If 2022 is the fourth year, then he will not qualify for 2023 for the AOTC. Consider if the Lifetime Learning Credit is applicable.

An eligible student for the AOTC is a student who:

• Was enrolled at least half-time in a program leading toward a degree, certificate or other recognized educational credential for at least one academic period during the tax year,
• Has not completed the first four years of post-secondary (education after high school) at the beginning of the tax year,
• Has not claimed (or someone else has not claimed) the AOTC for the student for more than four years, and
• Was not convicted of a federal or state felony drug offense at the end of the tax year.

See here and here for more information from the IRS on this topic.

[Edited 02/16/2023| 9:55am PST] 

@chrisgh

[Hal_Al · Accepted solution]

Q.   Would it make sense for us to decline the $2 AOC for 2022, so that my son has the option to claim his 4th year of AOC against this last semester (tuition after scholarships will be over $5000) on his 2023 taxes ?

A. Yes. 

That said, there are some options for 2022, particularly if there will be more 1099-Qs for 2023. It may be better to pay a little tax on the 1099-Q (or on his scholarships, if any) so that you can claim the AOC.  

__________________________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

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 $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

There is  $1120 of taxable income (on the recipient’s return)

**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.

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." 

***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. Most people come out better having the scholarship taxable before the 529 earnings. 

[chrisgh]

Thinking further on 2022..adding to my confusion is that we have two 1099-Q's...1) from a state 529 for $1500 issued in my name & SSN and 2) from a Coverdale for $30,000 issued in my son's name & SSN.  Total qualified expenses = $47,500 ($31,500 withdrawals from these two accounts and a $16,000 scholarship).  

Does that mean 1) on my return, I report the $1500 1099-Q and list $5500 of the tuition expenses to cover the $1500 from the State 529 and the $4000 credit (even though with our income it looks like we may get $1000) and 2) on my son's return, list $42,000 in remaining qualified expenses (so as not to double dip) and then have $4,000 of  the scholarship (or withdrawals)  be taxed as income?   He is going to have to file 3 different state returns, so I not sure if this will be a complication.

Lastly, I'm considering seeing if it is more advantageous to not treat him as a dependent - his income is significantly lower so should be able to take a full AOC.  If I did that, given I still have a 1099-Q in my name for $1500, I assume I should take that much of the qualified expenses and leave him the rest?

[Hal_Al · Accepted solution]

Yes, you are understanding it correctly.

Does Total qualified expenses of $47,500 include room and board, books and computer? You can count those.

Q. Does that mean  on my return, I report the $1500 1099-Q and list $5500 of the tuition expenses to cover the $1500 from the State 529 and the $4000 needed for the credit?

A.  Yes.  But, if your income is in the  $160K-180K phase out range, you may want to only claim $2000 for the AOC, instead of $4000.  The first $2000  gets you 100% (before phase out).  The 2nd $2000 is only worth 25%. 

Q. On my son's return, list $42,000 in remaining qualified expenses (so as not to double dip) and then have $4,000 of  the scholarship (or withdrawals)  be taxed as income?

A. Yes. Depending on his other income, taxed scholarship is usually best.  It's not the withdrawal amount that gets taxed, it's only the earnings portion. 

Q. Lastly, I'm considering seeing if it is more advantageous to not treat him as a dependent - his income is significantly lower so should be able to take a full AOC.

A.  If he qualifies as your dependent, he cannot file as independent. He MUST check the box that says he can be claimed as a dependent.  

While technically there is a provision that allows your student-dependent to claim a federal tuition credit, from a practical matter it seldom works out.  A student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he/she supports himself by working. Hee cannot be supporting himself on student loans & grants and 529 plans and parental support.  It is usually best if the parent claims that credit.  
If the student actually has a tax liability, there is a provision to allow him to claim a non-refundable tuition credit. But then the parent must forgo claiming the student as a dependent, and the $500 other dependent credit.  The student must still indicate that he can be claimed as a dependent, on his return. This is worth up to $2500 (AOTC shifts to all non refundable)

Q.  If I did that, given I still have a 1099-Q in my name for $1500, I assume I should take that much of the qualified expenses and leave him the rest?

A. Yes

Q.   He is going to have to file 3 different state returns, so I not sure if this will be a complication?

A.  It depends on the states, but it's unlikely to make any  tax difference. It just makes filling out the forms harder

[chrisgh · Accepted solution]

Thank you!  Your answers are very clear and understandable.

I have a question with regard to the following Q&A below:

Q. On my son's return, list $42,000 in remaining qualified expenses (so as not to double dip) and then have $4,000 of  the scholarship (or withdrawals)  be taxed as income?

A. Yes. Depending on his other income, taxed scholarship is usually best.  It's not the withdrawal amount that gets taxed, it's only the earnings portion. 

He does have income from part time jobs, a signing bonus for a job starting in 2023, scholarships, and then the 1099Q reported withdrawals from the Coverdale.  When you referred to the "withdrawal amount" not getting taxed, but the earnings portion..were you referring to the money drawn from the Coverdale Account vice the scholarships?  I'm not sure why the scholarship would be better given I can provide the basis and Earnings for the Coverdale withdrawal.  

If it is better to use one or the other (scholarship vs. Coverdale), how/where does one make this selection in turbotax (I have the download edition)?

[Hal_Al · Accepted solution]

The scholarship is usually better because it is treated as earned income for purposes of calculating the student's standard deduction.  If he already has $12,950 of other earned income to offset his standard deduction, then it would be better to have the ESA earnings taxed instead.

Q. f it is better to use the ESA, how/where does one make this selection in TurboTax (I have the download edition)?

A. How? Very carefully. Enter the 10990-Q at the 1099-Q section and the expenses at the 1098-T section.  You should eventually reach a screen called "Amount used to calculate education deduction or credit" Be sure the amount in that box is $5500  (or whatever the parent used used). Check the student information work sheet (part VI, line 17) to verify it was entered. 

Be advised some people (last year) were saying they're not getting the "Amount used to claim the tuition deduction or credit" screen on the dependent’s interview.  If not, the alternate workaround is  to enter $5500 (or whatever the parent used) less than the actual box 1  amount, when you enter the 1098-T. 

With download TT, you can also make any needed adjustments on the student info worksheet

Q. If it is better to use scholarship , how/where does one make this selection in TurboTax ?

A. The question is academic, in your case, since you will be entering the ESA earnings as taxable income. But, for others reading this: After entering scholarship at the 1098-T interview, you will be asked how much of the scholarship was used for room & board. Enter the taxable amount of scholarship there.  Since R&B is a non qualified expense, TT will treat that much as taxable. Note the wording at that screen “or other expenses”. You didn’t have to literally use the scholarship for R&B. 

[chrisgh]

Thank you...this is the first time I understand the logic of things.  Your answers were very helpful!

[chrisgh]

Everything worked as you noted -- what I want to confirm is that in a sense I had to"trick" the TT question menu for filling out the 1098-T information.  For example, on my return, I listed the 1099Q that was in my name for $1500 (which was accurate) but on the 1098T section, when TT asked what was reported in Box 1 -- I entered $5500  (vice the real much larger amt on the real 1099Q).  On my son's return, I listed the 1099Q that was in his name with its correct amount, but then on his 1098T section, listed Box 1 as the real tuition listed in the 1099Q less $5500.   Looking at the worksheets, it is clear that  the combined adjusted Qualified Expenditures are correct (and what was withdrawn from the 2 education accounts).  I can also see that TT had him pay tax on the excess distribution of $4000 (or more accurately only the earnings on that distribution). And we got the credit.  Many Thanks!

[Hal_Al]

Q.  I want to confirm is that in a sense I had to "trick" the TT question menu for filling out the 1098-T information. 

A.  Yes.  But, a different way of looking at it: You only had to do the math to adjust the numbers because TT isn't capable of handling the information overload.