Determining taxable portion of 529

[JAW29]

My child is a first year college student.  We were not knowledgeable about the AOTC so we withdrew funds from an 529 plan to cover tuition (amount remaining after scholarship was applied...$6527) and room and board ($11285).  We also paid $700 out of pocket for books and an enrollment deposit totaling. In maximizing our refund TT adjusted our 529 distribution to non-taxable and taxable amounts so that we can qualify for the $2500 AOTC. Great! However the taxable amount of the 529 that is now appearing on line 8 is $3970 and there is no link to the formula, amounts, and calculations used to determine this amount.  Using the formula of qualified expenses / total distribution X earnings  I can back into the numbers and see that it is only applying the $11,285 of room and board as qualified expenses.  The $6527 remaining tuition cost and $700 out of pocket costs were not included in the calculation.  Why is turbo tax not applying these amounts to qualified expenses and then removing the $4000 from that amount that would allow for the AOTC? 

Currently the calculation is:

$11,285/$17,812 X $10,835 (earnings) =$6,864.   $10,835-$6864=$3,970

I believe it should be this: $11,285 (room and board) +$6,527 (remaining tuition after scholarship) +$700 (out of pocket qualified cost) - $4000 ( amount that needs to be removed from qualified expenses to qualify for AOTC) so the calculation would be:

$14,512/$17,812 X $10,835 = $8,828 (non-taxable)  $10,835-$8,828= $2,007

This means that line 8 on the 1040 should be $2,007 not what TT calculated as $3,970.  What am I  missing? Why did TT not included these other amounts as qualified expenses? Thanks in advance!!

[Hal_Al]

Your calculations are correct.

Q.  Why is TT doing it wrong?

A.  It's complicated and getting the entries just right is difficult. Short cuts might be needed. 

Are you entering the 1099-Q on your return or the student's return (which one of you is the recipient)?

Does the student have any other income of his own? 

Is the scholarship restricted? That is, must it be allocated to tuition?  Making some of the scholarship taxable is frequently better than paying tax on the 529 distribution.

[JAW29]

You're the best, Hal!

To answer your questions:

I entered the 1099-Q on my (parent's) return. I am the recipient and my student is the beneficiary. The 529 distribution was sent to my bank account and then I sent a payment to the college. 

Student had income from a summer job but did not make enough to trigger the need to file a return.  Scholarship is not restricted but for we are treating it as non-taxable so it went solely towards tuition fees ( in our calculations and that is how we entered it into TT) We didn't want to deal with kiddie tax etc. so we're okay with having a portion of 529 become taxable. 

I am just trying to determine now how to best change the amount shown from $3970 to $2007 on line 8 of the 1040.  Is the best option to do an override on the Form 1040/ SR 1040 Worksheet and keep my handwritten calculations if needed in the future?  Thanks again!

[Hal_Al]

You'll only need to treat $4000 of the scholarship as taxable to wipe out the tax on the 529 earnings (and the need to even enter it on your return).  If that $4000 plus his summer job income is less than $14,600 there will be no  tax and no kiddie tax to deal with. Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024) and the dependent standard deduction calculation (earned income + $450).  It is not earned income for the kiddie tax and other purposes (e.g. EIC).  

That said, here's quick workaround in TurboTax, for handling the 529 earnings. 

Enter the 1099-Q. When asked who the student is answer: someone else not listed here (lying to TurboTax to get it to do what you want does not constitute lying to the IRS).  Enter the student's name when asked.  A few screens later, you'll get one simple screen to enter expenses. Press Done at the 1099-Q summary screen, to get there. Also enter the amount of the scholarship plus the $4000 you used for the credit in the box "Tax-free assistance".  This reports the earnings as taxable and claims the scholarship/tuition exception. You do not have to deal with the complicated “Educational expenses and Scholarships” (1098-T) section later. TT will prepare form 5329 to claim the penalty exception. 

[Hal_Al]

Clarification: if you are only gong to enter $6527 of tuition expense, then you only enter  the $4000 you used for the credit in the box "Tax-free assistance".  

[JAW29]

Awesome, Hal! Thanks for the workaround  and the information about using the scholarship rather than the 529 to for the 'taxable' $4000 so we can qualifyfor the AOTC. If that removes the additional income from us that would be best. She earned around $5000 last year so with the addition of the $4000 from the scholarship she shouldn't need to file but would the kiddie tax still apply to that 'unearned ' $4000? Thanks!

[Hal_Al]

Q.  She earned around $5000 last year so with the addition of the $4000 from the scholarship she shouldn't need to file. Is that correct?

A.  Yes. More accurately, she is not required to file, because her total income is under the $14,600 filing requirement.  You may want to have her file just to document the reporting of the scholarship as income. 

Q. But would the kiddie tax still apply to that 'unearned ' $4000?

A. No. It never makes it to the kiddie tax form, because her standard deduction ($5000 + 4000 + 450 = 9550) wipes it all out.  Or another way to say it:  the "hybrid earned income" never transitions from earned to unearned income because it's less than $14,600. 

[JAW29]

Got it...I've read a lot of posts on this topic over the past several days and you definitely are the expert. Hope this thread can save someone else from those hours of research 🙂 !

Thank you again for your help!