Student's income and 529 withdrawal

[rks2]

Hello,

My son is Junior in college, he made around $17K through work at college and summer internship. He received scholarship of 11K. His expected expense for tuition, boarding, books, etc is expected to be around $27K. I will be claiming him as a dependent when filing tax next year. Could you please help with the below questions.

1) Would I still be able to claim American Opportunity credit as I have paid for this qualified expenses (housing, etc.,)
2) Would any withdrawal from 529 be considered as additional earned income in this scenario.
3) I believe my son would have to file tax and pay income tax for the earned income of $17k, is this correct.

Thanks in advance.

[Hal_Al · Accepted solution]

Q.1) Would I still be able to claim American Opportunity credit (AOC) as I have paid for this qualified expenses (housing, etc.,)?

A. 1).  Yes, probably.  Room and board are not qualified educational expenses (QEE) for the AOC.  Tuition, fees, books and course materials (including a required computer) are qualified expenses.  See "loop hole" below (separate reply) for how to claim AOC when most QEE are covered by scholarship.  The fact that you didn't actually pay his QEE does not disqualify you.  He just needs to have QEE. 

Q. 2) Would any withdrawal from 529 be considered as additional earned income in this scenario?

A. 2)  It is not earend income, but some of it could be (unearned) taxable income.  Room and board (even off campus) are qualified expenses for a 529 withdrawal. See example in my 3rd reply about 529 distributions, in general.

Q. 3) I believe my son would have to file tax and pay income tax for the earned income of $17k, is this correct.?

A. 3).  Yes.  The general filing requirement for a dependent is $12,950 of income (2022).  See 4th reply for the details about that subject. 

[Hal_Al]

American Opportunity Credit  Scholarship “loop hole” .

The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), 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 or if the school’s billing statement specifically shows the scholarships being applied to tuition.

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.

Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials,  she would only need to report $5000 of taxable scholarship income, instead of $6000.

[Hal_Al]

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

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 $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

**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. Most people come out better having the scholarship taxable before the 529 earnings. 

[Hal_Al]

Dependent Filing Requirements

You do not report his/her income on your return*. If it has to be reported, at all, it goes on his own return. If your dependent child is under age 19 (or under 24 if a full time student), he or she must file a tax return for 2021 if he had any of the following:

1.          Total income (wages, salaries, taxable scholarship etc.) of more than $12,550 (2021) or $12,950 (2022).
2.          Unearned income (interest, dividends, capital gains, unemployment, taxable portion of 529 distribution) of more than $1100 ($1150 for 2022)
3.          Unearned income over $350 ($400 for 2022) and gross income of more than $1100 ($1150 for 2022)
4.          Household employee income (e.g. baby sitting, lawn mowing) over $2300 ($12,950 if under age 18)
5.          Other self employment income over $432, including money on a form 1099-NEC

Even if he had less, he is allowed to file if he needs to get back income tax withholding. He cannot get back social security or Medicare tax withholding.

In TurboTax, he indicates that somebody else can claim him as a dependent, at the personal information section.

*If his only income is from interest and dividends, Alaska PFD or capital gains distributions shown on a 1099-DIV, there is a provision for entering it on your return, using form 8814. 

[rks2]

Thank you so much for your input and additional details in multiple sections. This is super helpful for the filing next year.