Florida Prepaid and Bright Futures: excludes AOTC and forces Scholarship into taxable?

[Cygnify]

My son is in his first semester at UF; we have Florida Pre-paid (Tuition only) and he got the Florida Bright Futures Scholarship. The University applied pre-paid first to his Tuition, then Bright Futures covered any remaining fees and his entire dorm contract.  We are paying food as we go and plan to withdraw from a 529 for food up to the school's COA estimate.

It appears that a Florida Pre-paid plan / Bright Futures combination excludes the possibility of getting AOTC, since those two combined covered all Tuition and Fees.   (this is quite disappointing to me as it appears that I would have been better off just to pay tuition out of pocket and get the AOTC, but now I am stuck with a plan. The earnings on the pre-paid are quite minimal.)

Additionally, because the school applies the pre-paid to tuition first, part of the Bright Future scholarship ends up covering dorm; which I understand makes the scholarship taxable (or at least a majority of it taxable).  My son hasn't yet filed a federal return - and only had minimal tutoring income last year - should he file and claim the scholarship? and can he do so if I still list him as a dependent?  

The Pre-paid plan seems to be a double-whammy of negatives - I miss out on AOTC and it pushes scholarship into taxable space.  Am I seeing that correctly?  Anything I can do mitigate that situation? 

[Hal_Al · Accepted solution]

Q. Am I seeing that correctly? 

A. Yes

Q. Anything I can do mitigate that situation? 

A.  Maybe. You may need to consult a tax expert familiar with the prepaid plan rules.

Here's what you want to do: treat the FL prepaid plan distribution as a taxable distribution, since the "earnings are quite minimal" or apply it to room & board and other non-qualified expenses.  I don't know the FL plan rules. The school applying this to tuition may or may not be binding, at tax time.  Hence the need for a local expert .   If allowed, you then use the tuition (plus books & fees)  paid to claim the AOTC. 

The scholarship is taxable on the student's return, since it did not go for qualified expenses (Tuition, fees and course materials). He has to fila a return if his total earned income and scholarships is more than $12,200.  It is recommended that he file with even less, to document the reporting of the scholarship income, so that the parents can justify claiming the AOTC. 

Q. We  plan to withdraw from a 529 for food up to the school's COA estimate.

A. You cannot double dip.  But you can apply the 529 plan money (to room & board) ahead of the scholarship money, since the scholarship is treated as taxable.

If you do consult an expert, please let us know what they say. 

For more info, see "standard answers" (not specific to your situation) below.

______________________________________________________________________________

Scholarships & AOTC 

 There is a tax “loophole” available. The student reports all his scholarship, up to the amount needed to claim the American opportunity credit, as income on his return. That way, the parents  (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship.  You cannot do this  if the conditions of the grant are that it be used to pay for qualified expenses.

Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.

This is not some sinister scheme. From the 2019 form 1040 instructions (pg 95): “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040, line 18c, and IRS.gov/EdCredit.  Page 16 of PUB 970 (2019) actually has examples of how to do the “loop hole”.

_____________________________________________________________________________

Qualified Tuition Plans & 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.

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.

[Carl]

I'm confident you already know much of the below. But I'll state it anyway for clarity since 2020 is your son's first year in college.

The Florida Bright Futures is a scholarship. It can only be applied to the "qualified" education expenses of tuition, books, and lab fees. That's it, with no exceptions. (Though the category of "lab fees" is rather broad).

If, after paying those qualified expenses from the Bright Futures scholarship, there is anything left over, that left over amount is taxable income to the student.

The Florida Prepaid is basically a Coverdell/529 plan. These funds can be used tax-free for the qualified education expenses mentioned above, and also for the cost of room and board. But there are limitations that many fail to realize on the room and board part. I'll cover that later.

When the school receives money on behalf of a student, it gets applied in a specific order and we have no say on that.

First, scholarships are applied to the qualified education expenses of tuition, books and lab fees. If there is any excess, then that excess is reportable (and possibly taxable) income to the student - not the parent.

Second, 529 funds are applied to any remaining qualified education expenses, and can also be applied/used for the cost of room and board *provided* that room and board is in direct support of the education.

Lastly, if there are still qualified education expenses to be paid, then "out of pocket" money is used last. That could be money out of anyone's pocket, including the parents, the student, grandma, or anyone else. That "out of pocket" money is basically money that has already been taxed in some way. If used for the qualified eduction expenses of tuition, books and lab fees then that money will be "un" taxed and any taxes withheld on it will be credited or refunded.

In your specific case sicne the student qualifies as your dependent (and assuming you actually claim them as your dependent) the credit for out of pocket expenses is taken by you the parent, and it does not matter who actually paid those expenses. Now on to the "room and board" part as it applies to 529 funds.

529 funds must be used in the same tax year they are withdrawn. Period. If they are not, then the withdrawal is a taxable event. Period. When it comes to using 529 funds to pay for room and board, that room and board must be "in direct support" of the education, and in some situations the amount you can claim can be limited too.

Now there are two parts to this. First there's the "room" which is the cost of having a place to sleep.  Then there's the "board" which is basically the cost of food.

The "room" part includes rent, utilities and any maintenance expenses (which are not common for an undergraduate) incurred to maintain the facilities. If the student is living on campus, then the monthly rent they pay for that already includes utilities and maintenance costs and is a totally tax exempt expense.

The "board" part is for food. I already know that UF offers a food plan. (Actually 3 food plans of different costs, depending on the need.) What you pay each semester from the 529 funds for that food plan is not taxable income. Now lets move to a student that lives off campus.

If the student is renting off campus housing, that too is a deductible expense when paid with 529 funds. However, what you claim against the 529 funds can not exceed what it would cost the student to live on campus. The one exception is if the student received a letter informing them that on campus housing was not availalbe and they have no choice but to seek housing off campus. In such a case it's no problem to claim the full cost of rent and utilities for the off campus housing. Just keep in mind that the costs must be reasonable for the area. In other words, no $5000 a month penthouse suites. That's not gonna fly with the IRS for an undergraduate.

If the student is living off campus by choice (and not because on campus housing is not available) then what they claim for food (the "board" part) can not exceed what it would cost them for the on campus meal plan. But if living off campus because on campus housing is not available, then no problem with the cost of food. But again, those costs are expected to be reasonable. In other words, steak and eggs for breakfast with lobster for lunch and dinner every day are just not going to cut it with the IRS.

Basically, if you don't have any qualified out of pocket expenses (room and board does not qualify) then you have no claim to any of the education credits. There are some loopholes you "may" be able to work. But in the end it all "works out in the wash" and what you may gain now, will just be lost later.  A few things to keep in mind during your son's school years:

- Colleges work in academic years, while the IRS works in calendar years. So the reality is, it takes 5 calendar years to get that four year degree.

 - Scholarships, grants and 529 distributions are reported as taxable income (initially) in the tax year they are received. It *does* *not* *matter* what tax year that income may be "for".

 - Qualified eduction expenses are reported as such in the tax year they are paid. It *does* *not* *matter* what year is paid *for*.

I point this out, because many of the education credits can only be taken for four calendar years, and that's it. So you may find it in your best financial interest to pay for the last semester of the senior year (which will start in the 5th calendar year of school) before the end of the first semester of the senior year. That way, if you have out of pocket expenses when you pay for that final semester, you can claim all the education credits you qualify for with no worries about having claimed it four times already.

Finally, if the total of all scholarships, grants and 529 distributions received in 2020, exceed the total of all qualified education expenses paid in 2020, then while you will still claim the student as your dependent, it is the student (not the parent) that will report all the education stuff on the student's own return, provided the student meets the criteria that requires them to file a return.

[Cygnify]

Thank you very much for your informative reply!  I do really appreciate it!  I've done some more research, and with some guidance from your reply (and Carl's below), I think I have a clearer picture of how to "optimize" my savings and use of them for DS' education.  I see this "optimization" in the following steps:

1.) FLORIDA PRE-PAID.  I did some more research into my Florida Prepaid plan - and re-discovered a benefit long forgotten that changes some things.  Specifically, because I purchased my Prepaid plan before 2007, the year the state of Florida instituted an additional "Differential Tuition", I am exempt from this differential tuition. This amounts to ~$662 of additional tuition (per 15 credit semester) that I am exempt from paying when my Prepaid plan is used against tuition.  I knew this back in ~2007 time frame, but it was long forgotten, and appears nowhere on my current bill... but it is a significant benefit for me in using the Prepaid considering I paid ~$2940 for 30 credits which currently cost $4837 (when "Differential Tuition" is included).  I did a little side-by-side comparison of using the Prepaid vs. using out of pocket (OOP) funds and claiming AOTC.  For ~30 credit year (2 15 credit semesters), I get about $940 more value if I use the Prepaid vs OOP. 

2.) FEES/BOOKS OOP.  Additionally, I have also learned a little "trick" by which I can use OOP (taxed) funds to pay for the remainder of Fees & Books (after Tuition) by depositing this OOP money PRIOR to the Bright Futures Scholarship being applied to my son's account (usually a month after semester starts). I understand that the OOP funds used toward Fees&Books can then be claimed for some AOTC (I missed this opportunity for his 1st Fall semester and the Scholarship paid for all these remaining fees; this was ~$880 that could have been paid OOP and qualify for AOTC. Oh well, live and learn - I will get it for the remaining years.) 

3.) ROOM w/ 529. After Tuition, Fees, Books are all paid for, there is still "Room" which for the Spring 2021 (at least) will be on campus and thus is billed via the Bursar.  I can also pay this OOP - "Room" does not qualify for AOTC, and will not be claimed as such, but I can withdraw from his 529 account tax free in the same calendar year to reimburse myself. 

QUESTION1: Should the withdrawal be directed to my DS (the "beneficiary) and then does the resulting 1099-Q from this withdrawal get reported on DS' tax return?

For Future semesters after next Spring, he may very well be Off-campus, and thus, I believe I can take 529 withdrawals, equal to the "ROOM" cost on-campus, for the semesters that he is enrolled at least 1/2 time, to reimburse the OOP expense of Room.

 4.) SCHOLARSHIP.  After DS' account has tuition, fees, books, and ROOM covered by the above (should clear his account to $0 balance for the semester), his Bright Futures Scholarship will hit his account. I need to check with the Bursar, but I believe after his semester bills have been paid, any remaining money (his scholarship) can be withdrawn to his personal account.  This is then taxable money and DS will have to claim it as income on his return.  Since DS does not yet have any additional reportable income, his total income including the scholarship will likely be less than the threshold noted ($12.2k/year?)  Although he would not be required to file a return, he still should do so in order to show the scholarship being claimed as taxable to him and supporting my taking the AOTC for the amount I pay OOP for FEES/BOOKS. 

I think DS and I will have an arrangement that the Scholarship money will be used to "leap frog" payments for each successive semester - for example, Spring 2021 scholarship money will sit in his account and then be used to "pre-fund" his Fall 2021 semester as OOP money and this can carry forward each semester. 

QUESTION2: Is it important from whose account the OOP money comes from, if the parent claims AOTC and the student receives scholarship and 529 funds (as the beneficiary)? 

5.) "BOARD/FOOD" Finally, as we have not purchased a meal plan, even though my DS is on-campus as he pays for restaurants/groceries as he goes, I can withdraw from his 529 account up to the amount of the cost of a meal plan (assume the 7-day plan; he eats more like 11 days in that time... lol) as long as he is actively enrolled at least 1/2 time that semester, all during the same calendar year.  This will be the same if he goes off-campus in the future.  He will incur food charges (paid w/ cash and credit card) and we can withdraw 529 funds to pay us back during the same calendar year. Board/food does not qualify for AOTC and will not be claimed as such. 

QUESTION3: as above, if this 529 "reimbursement" goes directly to DS "beneficiary", does the 1099Q go on his tax return; do I make any note of it on my return?  

QUESTION4: the question of receipts for off-campus food expenditures appears all over internet forums.  There are "authoritative voices" on both sides of that one.  I think you have to be able to show that you "incurred" that expense, but looking at Pub. 970 it appears that as long as you're below the amount of "BOARD" for the on-campus / cost-of-attendance meal plan cost, this amount is qualified as long as you're enrolled >1/2 time and withdraw taken in same calendar year as the claimed expense. It does not mention receipts;  I am pushing son to try to keep as many as he can though it is clear that we won't account for 100% of his food spending.  Are receipts necessary?

Thanks again for your kind assistance and I would certainly appreciate any correction of the above think or response to my 4 additional questions.  Thank you.

[Hal_Al]

QUESTION1: Should the withdrawal be directed to my DS (the "beneficiary) and then does the resulting 1099-Q from this withdrawal get reported on DS' tax return?

ANSWER 1: Simple answer: it doesn't matter if it's all used for qualified Expenses, including room and board, since none of it is taxable income.  If a small amount of it is going to be taxable, the dependent student is usually in a lower tax bracket than the parent.  But, the kiddie tax could kick in, with higher amounts, as taxable earnings are not earned income.  The only way to be sure is calculate both ways. 

QUESTION2: Is it important from whose account the OOP money comes from, if the parent claims AOTC and the student receives scholarship and 529 funds (as the beneficiary)? 

ANSWER2: No.  Although in taxes, the general rule is YOU must pay it to deduct/claim it, there is an exception for educational expenses.  One unlikely scenario: if he pays too much of his own support, he might not qualify as your dependent.  Scholarships, 529 and prepay plans are NOT considered support provided by the student. 

QUESTION3: as above, if this 529 "reimbursement" goes directly to DS "beneficiary", does the 1099Q go on his tax return; do I make any note of it on my return?

ANSWER3: Yes, it goes on his return. You make no note on your tax return, but do adjust the expenses  you claim (don't double dip). Again, he does not need to report it if was all used for qualified expenses. 

QUESTION4: the question of receipts for off-campus food expenditures appears all over internet forums.  There are "authoritative voices" on both sides of that one.  I think you have to be able to show that you "incurred" that expense, but looking at Pub. 970 it appears that as long as you're below the amount of "BOARD" for the on-campus / cost-of-attendance meal plan cost this amount is qualified as long as you're enrolled >1/2 time and withdraw taken in same calendar year as the claimed expense. It does not mention receipts;  I am pushing son to try to keep as many as he can though it is clear that we won't account for 100% of his food spending.  Are receipts necessary?

ANSWER4: Probably not. But, as you already determined, there's not a clear answer out there. Most people (including me) are hanging their hat on the IRS will accept the school's cost-of-attendance meal plan cost.

[Cygnify]

Thank you so much for the clarifications! These are all quite helpful

One item that remains a bit hazy for me...

So, if my son's scholarship amount (~$3300 for the Fall) exceeds the qualified tuition expenses (the school charges were only ~$1000 after my pre-paid is applied; also, there were other qualified expenses this Fall not charged by school, like a required computer), but I previously paid out of pocket for some qualified expenses (some Fees that will be reported on 1099-T and required computer equipment that will not be reported on 1099-T ~$2000 this year) which of the following is correct:

1.) Can I choose to consider those OOP expenses on my return in order to claim some AOTC, and have my DS pay tax on the scholarship

-OR-

2.) Must I reduce the amount of taxable scholarship by ALL of the qualified expenses (either on 1099-T or not), not take any AOTC, and have DS pay tax on any remaining scholarship amount

Is the application of scholarship vs. OOP funds even an option/choice? (I have read some other threads here and elsewhere that make me think it is a CHOICE; I have seen it stated ~"I opted to treat the scholarship as taxed so that we may claim AOTC")

I am looking forward to next year, with likely 2x scholarship amount (~$6600?) and no additional computer expense, but only ~$1800 in Qualified Fees not covered by my pre-paid 529. The scholarship could cover that, but can I CHOOSE to pay out of pocket (and eventually claim that ~$1800 AOTC) and have DS pay tax on the full scholarship? It's better to get the tax credit and pay tax on the full scholarship on DS' return - even with revised new "kiddie tax" rules  (as little as I understand this without running this through TT), I think DS would be exempted from the first $1100, pay $0 tax on the next $1100, and then pay my marginal tax rate 22% on the remaining ~$4800 = ~$1056 tax (??) I would, in this case, still have a net positive tax credit vs. letting the scholarship cover the fees, get no tax credit, and pay a tax on the reduced remaining scholarship amount.  Given the choice, it's clear that getting credit is better, but is it a choice?

[Carl]

Here's the part I can answer with certainty.

there were other qualified expenses this Fall not charged by school, like a required computer), but I previously paid out of pocket for some qualified expenses (some Fees that will be reported on 1099-T and required computer equipment that will not be reported on 1099-T ~$2000 this year)

Of the three identified qualified education expenses, (tuition, books, and lab fees) the computer, and any other requirement identified in any class syllabus which you purchased for the primary reason of satisfying that syllabus, falls under the "lab fees" category. Therefore it's a qualified expense that can be used against scholarships, grants, 529 distributions, and/or out of pocket expense.

Not all qualified education expenses are always included on the 1098-T. That's why the program will, a few screens after the 1098-T entry, specifically ask you for qualified expenses that were not included on the 1098-T.  This is where being able to track the flow of money can come into play if you are ever audited.

You can get the details by having the student log into their college web account and go to the financials section. That takes care of the totals shown on the 1098-T. Then for those things you're claiming that were not included in the 1098-T amounts, maintaining receipts is all you need to justify the additional costs "should" you be audited. If you're never audited, then nothing to worry about. If you are audited and have receipts, then there's still, nothing to worry about.

[Hal_Al]

Q. Can I choose to consider those OOP expenses on my return in order to claim some AOTC, and have my DS pay tax on the scholarship? 

A. Yes.

Q.  Must I reduce the amount of taxable scholarship by ALL of the qualified expenses (either on 1099-T or not)?

A. No, unless it is a condition of the scholarship that funds be used for those qualified expenses.  It would be unusual for the scholarship to to require that on non 1098-T fees. 

Q. Is the application of scholarship vs. OOP funds even an option/choice?

A. Yes, except when it's a condition of the grant.

Q.  I think DS would be exempted from the first $1100, pay $0 tax on the next $1100, and then pay my marginal tax rate 22% on the remaining ~$4800 = ~$1056 tax (??)

A.  Generally correct, except the 2nd $1100 is taxed at 10%, not 0%.  But it gets better.  A  Dependent student  (DS) is allowed a standard deduction of $1100 (hence the first $1100 being "exempt") or his earned income + $350.  For purposes of calculating the standard deduction, scholarship income (but not taxable 529 or prepaid plans) is treated as earned income.  So if a DS had $6600 taxable scholarship, none of it would be taxable as his standard deduction would be $6950.  So, having taxable scholarship is usually better than having a portion of the 1099-Q be taxable, on the student's return.

[Cygnify]

Thanks again for another helpful response - you're very kind!

It occurred to me that since it is a choice of whether to make the scholarship taxable or not, does it really matter if I try to maneuver out-of-pocket funds into DS' account to justify the AOTC, or if I choose to make the SCH taxable the moment he receives it, and it is immediately as good as my own OOP money?

Seems silly to me now, but I suppose I am a little confused because my son receives the scholarship money in his account, and receives the 1099-T, and pays taxable scholarship on his return - but I claim AOTC based on that scholarship being treated as taxable...  I guess since I declare him as a dependent, his taxable scholarship is treated like my out-of-pocket money?  

[Hal_Al]

Q. Does it really matter if I try to maneuver out-of-pocket funds into DS' account?

A. Simple answer: no.  As long as the student is claimed as a dependent, on your return, you can claim the AOTC, whether expenses were paid with your out of pocket (OOP) or his or anybody else's (e.g. grandparents or taxable scholarship) 

Q.   Since I declare him as a dependent, his taxable scholarship is treated like my out-of-pocket money? 

A.  Not exactly.  It just doesn't matter who's OOP it is, as long as he is your dependent. 

[Cygnify]

Thanks again;  one last question is nagging at me and Pub. 970 has some wording that isn't entirely clear on the following:

I understand from our discussion above that if my student receives a scholarship which we elect to include in taxable income - and part of that scholarship was used by the University's Bursar to pay for QEE (tuition & fees), I can claim that amount on my return for AOTC.  Now here's the hazy part, in my DS' case, after QEE were all paid up, additional scholarship funds remained, which the Bursar applied to his ROOM charges at school.  These additional funds are taxable no matter what - as ROOM is not a QEE.  Since his ROOM was paid with these taxable funds, can I remove an equal amount from a 529 tax-free?

I realize there is no "double dipping", but I don't think that is what is occurring here.  The part of the scholarship not applied to QEE is always taxable and will be claimed on his return.   The school applied these funds to his Dorm Room (depleting the scholarship for the semester).  The school has indicated that any remaining funds could go in DS' bank account (and could be used for anything; in the future, this could be his off-campus rent.) 

Some of the language  of Pub 970 makes me think that the use of the taxable scholarship funds is limited ("If this situation applies, consider including some or all of the scholarship or fellowship grant in the student's income in order to treat the included amount as paying nonqualified expenses instead of qualified education expenses. Nonqualified expenses are expenses such as room and board that aren't qualified education expenses such as tuition and related fees" ) It would seem to me that once the scholarship is taxable, it could be used for anything - beer, football tickets, car expenses, etc. not necessarily room & board. Since this taxable income (that originated as the scholarship) was used for his Room at college (a 529 eligible expense), it would seem to me that it would justify tax-free withdrawal from a 529 fund in an equal amount.  Am I interpreting this correctly? 

[Carl]

Since his ROOM was paid with these taxable funds, can I remove an equal amount from a 529 tax-free?

No, unless you return it to the 529 account within 60 days after the withdrawal.

It would seem to me that once the scholarship is taxable, it could be used for anything - beer, football tickets, car expenses, etc. not necessarily room & board

That's absolutely true. But sometimes the school will actually hold those funds instead of refunding them to the student. That's why, when your scholarships awarded in a tax year exceed the qualified expenses paid in that same tax year, the program will ask you if any or all of the excess was held by the school. If yes, then it's assumed the school will apply that 2020 excess to qualified expenses in 2021, and that amount held back by the school won't be treated as taxable income.

However, it's up to you to track that for 2021 tax reporting. That's because if say for example, the student drops out in 2021. Then the school would refund the excess to the student if the student dropped out for a qualified reason. That would then make it taxable in 2021.

As for the wording in pub 970 - while most things are crystal clear in their clarity, there are those things that are open to interpretation. So while the document is "good" at covering everything, it's not what I would call "stellar" at explaining it with clarity.

[Hal_Al]

Q. Since his ROOM was paid with these taxable funds, can I remove an equal amount from a 529 tax-free?

A.  Yes.  I know that may disagree with @Carl answer.

The school applying the taxable scholarship to room and board  (R&B) does not lock you into saying it was  used for R&B, at tax filing time, unless it was a condition of the scholarship*.  You may withdraw that much from your 529 plan.  You don't actually have to pay R&B with those specific funds.  You only need to have that much R&B expenses in same tax year as the 529 distribution.

I agree with your analysis,  once the scholarship is taxable, it could be used for anything - beer, football tickets, car expenses.  You are I interpreting this correctly.  One way to think  of it: you only borrowed  money from your son's taxable scholarship, to pay R&B, until you reimbursed yourself with 529 money.

*Although some (a few) scholarships have condition that the grant be used for tuition and fees, a R&B condition is even rarer.

[Carl]

I've never seen a scholarship with any amount designated for room and board. But I have seen where a grant may have funds (dollar amount or percentage) designated for R&B.

As far as I can tell, that's one of the major differences I see between a scholarship and a grant.

Hal_Al is right and I"m not in disagreement. Just because the school used a scholarship for a specific expense, does not mean you are required to "apply" that expense as used, at tax time.