529 and electing not to be dependent?

[BAqs]

My son, 22 years old, graduated with a undergraduate degree from an out of state college in May 2024. We paid only the tuition and fees using his 529 account (my husband is the owner of the 529). 

He worked at school and has a W-2 from there and over the summer, he had an internship and has a W-2 from there too. 

In the fall, not getting a job, he decided to go to an in-state grad school for a Master's full time not living at home and paid his own way from September - December 2024 for tuition and room and board. We, the parents have a MAGI that exceeds the dependent credit.

1. Can we stop claiming him as a dependent on our taxes, even though he is a qualifying child as a full time student for most of the year?  

2. What we paid from the 529 for his last semester undergraduate tuition far exceeds his grad school tuition and living, but not what he earned in total W-2 income for the year. Will that be a problem for his taxes as he files on his own and does NOT check 'Can someone claim you as a dependent box' ?   Shouldn't that question be 'Will someone claim you...'?

[Hal_Al]

"We, the parents have a MAGI that exceeds the dependent credit."

The income limit for the tuition credit is $180,000. The income limit for the $500 Other Dependent Credit is $400,000.

Q. 1. Can we stop claiming him as a dependent on our taxes, even though he is a qualifying child as a full time student for most of the year and (I assume) he paid for less than half his own support?

A. Yes, you are allowed to do that.  But there is (probably) nothing to gain. With the tax law change, effective 2018, most students will get the same refund whether they claim themselves or not. The personal exemption has been eliminated and the standard deduction increased. However, he only qualifies for an education credit, if he is not 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 full time student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he supports himself by working. He cannot be supporting himself on student loans & grants and 529 plans and parental support.   

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). Grad students are allowed to claim the AOTC if they got their BA/BS the same year (and the parents had not previously claimed it 4 times).  

Q.  Will that (529 distribution) be a problem for his taxes as he files on his own and does NOT check 'Can someone claim you as a dependent box ?   

A. No. He must check that box.  More importantly, if he was the recipient of the distribution and1099-Q, and some of it is taxable, it goes on his tax return regardless of his dependent status. The kiddie tax will still apply to any unearned income, including the taxable portion of 529 distributions (if he was the 1099-Q  recipient).

Q.   Shouldn't that question be 'Will someone claim you...'?

A.  No. The 1040 form does not have that option.  But the TurboTax interview does and will allow him to proceed to claim the tuition credit (that an actual dependent cannot claim).

His off campus rent and food are qualified expenses for the 529 distribution but are limited to the school's "allowance for dependence" (basically what on campus students pay). 

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[BAqs]

Thanks for the reply, but the more times I re-read your answer, the more questions I have! 

The Turbotax interview questions  and FAQ are seriously lacking in this area.

Am I allowed to illustrate with actual numbers?

First I  looked back at all the past years TT returns and worksheets.

All years my son was in college, we never got any credits for anything at all related to him being a dependent because we were phased out by income limits, no traces of all the 1098-T and 1099-Q I was asked to enter in interview questions, so the plan is not to put him as a dependent in 2024.

But I am still unclear for his own taxes, hoping he does not owe taxes for our bad planning/using his 529.

What is the IRS definition of 'if he supported himself by working'?  Does it mean that calendar tax year?  Does it have to be W-2 income during the school year? Or can it be from savings of his summer internship income  of previous years and his capital gains only?   

Tax year 2022  - we put as dependent, paid all tuition from 529, all the rest from our savings, he answered yes to can someone claim you as a dependent, but had a well paid summer internship with W-2 income and paid his taxes, saved/invested his earnings.

Tax year 2023, same as 2022, had another summer internship with W-2 income and paid his taxes. Saved/invested that.

No 1098-T or 1099-Q interview questions were asked during his tax filing (used TT). No AOTC questions asked either.

Tax year 2024.

Last Undergrad semester of his BS, Spring 2024. 1098-T  Box 1  12724.  No scholarships.

Room and board from Cost of attendance for that semester from university website 8989 (paid by him, but his weren't that high) . 

Teaching assistant Spring 2024,W-2 1.5K,W-2 summer income approx 11.5k. Capital gains $7K. So approx 20k in 2024.

Grad school Fall 2024. 1098-T  Box 1 4965.68. No scholarships. Room and board from COA website 11574 for one quarter, but again he skimped and did not spend that much, although he has that much saved.

Should he still answer  Yes to 'Can someone claim you as a dependent?' even if he provided clearly over half his support. I think not.

Additional wrinkle -  he had leftovers in 529, so we paid Spring 2025 grad tuition of 5k from 529 in December 2024, even though he has enough in his own savings and it showed up in his 1099-Q for 2024. Was this a big mistake? Are there penalties?

1099-Q  for 2024 has 18087.25 in box 1. Earnings 3793.34, basis 14293.91. Distribution is from State checked.

 More confused.  Haven't even asked about kiddie tax. Just want to get this right for him.

[Hal_Al]

Q. Should he still answer  Yes to 'Can someone claim you as a dependent?' even if he provided clearly over half his support. I think not.

A. No.  But, from the info you provided that's not clear.  In particular, the support from the 529 distribution is considered as coming form you, not him.*  Even if he can't be a dependent, he needs to meet the separate  earned income rule for the refundable portion of the AOTC. 

Q. Additional wrinkle -  he had leftovers in 529, so we paid Spring 2025 grad tuition of 5k from 529 in December 2024, even though he has enough in his own savings and it showed up in his 1099-Q for 2024. Was this a big mistake?

A. Not a big mistake but hurts your desired outcome, of him providing more than half his support.

Q. Are there penalties?

A. No, since there were plenty of expenses to cover the distribution, even if he claims the AOTC

*The treatment of expenses paid with distributions from Sec. 529 plans and Coverdell ESAs in the support test is uncertain because of the dual nature of these college savings vehicles and a lack of IRS guidance. The consensus among tax experts is that it is parental support, because the parent is the owner of the plan.  It would be helpful (but not a guarantee), to your case, to make distributions to the  the beneficiary, not the owner . References: 

https://ttlc.intuit.com/questions/3402602-can-i-claim-money-from-a-529-fund-as-my-supporting-my-22-y...

https://ttlc.intuit.com/community/college-education/discussion/re-does-529-distribution-count-as-par...

[BAqs]

Thanks @Hal_AI, that helps a lot. 

He is the beneficiary, 1099-Q is in his name/SSN.

Not looking to get any tax breaks for him AOTC/LLC whatever, just don't want to do it wrong and deal with the fall out.

Will probably just take back the rest of his 529 or transfer balance to the other kid and make him do his own taxes for 2025, especially since he seems to have capital gains etc.,