Scholarships and 529

[I hate taxes 2025]

We have a complicated scenario.  My son has a lot of scholarship money and also made 529 withdrawals in 2024.  The rough numbers from his 1098-T are box 1 $14,000 and box 5 $36,000.  For some reason, he was led to believe that he could take 529 money out equivalent to his scholarship amounts without penalty, so he also took about $36,000 out of his 529.  He knew he would pay taxes on the $36,000 529 money but thought there would be no penalty.  (He does not need this extra 529 money for his education due to all of his scholarships and thought it would be wise to take it out while he is not making much money vs. when he is in a higher tax bracket in a few years). Now, it appears he is paying taxes on both the scholarship money, plus the 529 money, plus the 10% penalty from the 529, plus another penalty for not paying estimated taxes all year.  In addition, it appears he will be taxed in my tax bracket because they are asking him for my 1040 information.  Because of his scholarship money, it looks like we won't be able to get the education credit on our tax return either.  It's a mess!  Is there anything we can do to minimize his taxes owed?  

[AmyC]

If he is your dependent, he has a lot of income. Reducing your 529 distribution is the best you can do. If you qualify for an education credit, take it. 

If he is not your dependent, he might qualify for the education credit. See  What You Need to Know about AOTC and LLC.

Any scholarships restricted to tuition will have to remain as such. Otherwise, we can move numbers around. You will have to play with the numbers  and look at the scholarships. 

For the 529, it can be used on 529 qualified Room and Board to reduce the taxable amount. Best case scenario, the 529 is used up with qualified expenses after room and board- but I doubt that will happen. 

For the 1098-T- only $4k is needed to claim the AOTC, if qualified and able.

Putting this together:

Education credit takes $4k  from box 1 

This leaves $10k in box 1 to be covered by 529  preferably or scholarships if required.

The remaining scholarships and Q are taxable but the AOTC would go a long way to reducing the tax.

[Hal_Al]

Q. Is there anything we can do to minimize his taxes owed?  

A. Yes. The Good news:

1. He does not need to pay the penalty on the full distribution.  The scholarship exception still partially applies, despite all that messy detail

2. You CAN claim the tuition credit. He will just have to pay a little more tax on the scholarship (declare more of his scholarship as taxable; $26,000 rather than $22,000).

3. Not all of the 529 distribution will be taxable because room & board are qualified expenses only for the 529 distribution. It doesn't matter that scholarships actually paid for r&b.  R&B can be allocated to the 1099-Q, because the scholarship is already taxable income. 

4. The underpayment penalty (failure to pay estimates) doesn't apply if last year's taxes were low or zero. 

5. less than half the income will be subject to the  "kiddie tax" (kid pays at tax at parent's rate), depending on how much other income student has. 

Provide the following info for more specific help:

• Are you the student or parent.
• Is the  student  the parent's dependent.
• Box 1 of the 1098-T
• box 5 of the 1098-T
• Any other scholarships not shown in box 5
• Does box 5 include any of the 529/ESA plan payments (it should not)
• Is any of the Scholarship restricted; i.e. it must be used for tuition
• Box 1 of the 1099-Q
• Box 2 of the 1099-Q
• Who’s name and SS# are on the 1099-Q, parent or student (who’s the “recipient”)?
• Room & board paid. If student lives off campus, what is school's R&B on campus charge. If he lives at home, the school’s R&B “allowance for cost of attendance” for student living with parents.
• Other qualified expenses not included in box 1 of the 1098-T, e.g. books & computers
• How much taxable income does the student have, from what sources
• Are you trying to claim the tuition credit (are you eligible)?
• Is the student an undergrad or grad student?
• Is the student a degree candidate attending school half time or more?

[I hate taxes 2025]

Thank you so much for your response!  I cannot express my appreciation enough! To answer your questions...

Parent

Student is a dependent

box 1 $14,796

box 5 $35,849

no

no

yes- $5,017 tuition

box 1 $36,934.82

box 2 $21,359.34

Student is on 1099Q

Room and Board $11,672

Unsure about other qualified expenses - roughly $1,000 for a computer I think

Additional income- roughly $2,000 from internships

yes

undergrad

full time

[Hal_Al]

At tax time, you are (pretty much)  free to allocate your expenses where they will benefit you most.

-First we allocate $3000 of tuition + $1000 computer to the American Opportunity Credit (AOC).

-That leaves $11,796 of tuition for the scholarship

-$35,849 - 11,796  = $24,053 of the scholarship is taxable on the student's return. Taxable scholarship is earned income for purposes of the dependent's standard deduction.* So, he gets a $14,600 standard deduction.  It is unearned income for the kiddie tax. 

-We allocate the $11,672 Room & board (R&B) to the 529 distribution. This means the distribution is 11672 / 36935 = 31.6% qualified.  68.4% unqualified x $21,359 earnings = $14,610 taxable income from the 1099-Q. 

Theoretically you can enter 1098-T, in TurboTax (TT), on your return and  the 1099-Q),  then the 1098-T on the student's return , answer all the questions and TT will come up with those conclusions and put it on the forms.

But mistakes are frequent. I strongly recommend short cuts:

-On your return, enter the 1098-T with $4000 in box 1 and box 5 blank.

-On the student's return, enter the 1098-T with 0 in box 1 and $24,053 in box 5.

-On the student's return, 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 (enter all expenses, don't adjust). Press Done at the 1099-Q summary screen, to get there. Also enter the total amount of the scholarship in the box "Tax-free assistance". This reports the earnings as taxable and claims the scholarship 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. 

*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).  For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.

Taxable scholarship goes on line 8r of Schedule 1, from which TT treats it as hybrid income.