How do I fix TurboTax inflating our AOTC amount and then trying to tax gross earnings on 529 plan 1099-Q? 529 distribution is lower than qualified expenses.

[Hewie]

The software had me enter 1098-T info for my dependent student from the university. Box 1 is 11,385. Box 5 is 6,395. (qualified payments minus scholarships equals 4,990). Books and equipment expenses paid separately equals 885.38. In total, we paid 5,875.38 in expenses. 529 distribution amount on 1099-Q is 4,072. I expect AOTC amount to be 1,803.38 since I won't double dip with 529. However, TurboTax gives AOTC amount of 2,500. TurboTax did not direct me to enter any 1099-Q info so after finishing education credit section, I had to get link to help box to enter. Also, TurboTax states earnings on 1099-Q are taxable. I know the earnings aren't taxable since qualified distribution is less than qualified expenses. I know AOTC TurboTax calculation is too high. It should have factored in I cannot double dip and deducted 529 distribution amount from our qualified expenses before AOTC credit  was determined. How do I fix this? Our student only had 1,174 work income last year (no federal taxes withheld) and no unearned income, so she did not plan to file taxes.

[KrisD15]

The order the forms are entered makes a difference.

The 1099-Q should be entered in Income first.

When you go through the TurboTax Education interview, you will come to a screen that says "Maximize My Tax Break"

When you click this, the program will figure the best credit. In your situation, it appears the best option is to tax the distribution (claimed as income by the student) and take the credit. 

If you would rather not do this:

Go back through the Education Interview, click that last screen and allocate zero (0) towards a credit. 

You can also type   letme   into the search box and then click the "Jump to letme" link. Here you can change the credit TurboTax suggest you take. 

[Hal_Al]

TurboTax (TT) will automatically claim the AOTC and assign $4000 of the available expenses to it.  That reduces the amount available for the 529 1099-Q and some of it becomes taxable. The AOTC is more generous than the 529 earnings exclusion, so most people should go along with TT's allocation*.

Room and Board, even if the student lives at home, is a qualified expense for the 529 Distribution, so you should enter that to reduce the taxable amount. 

*If you want to change it, go through the entire education interview until you reach a screen titled "Your Education Expenses Summary".  Click edit next to the student's name. That should take you to a screen “Here’s your Education Summary”. Click edit next to “Education Information”. When you get to the screen titled “Amount Used to Calculate Education Deduction or Credit”, verify the amount you want to use or change it.

[Hal_Al]

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General discussion

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.