Q. Should I choose myself or my son as the 529 distribution recipient?
A. Your son, the plan beneficiary.
The savings isn't that much. Taxable 529 earnings are unearned income. As such, it is subject to the "kiddie tax", where the student's unearned income is taxed at the parent's tax rate. Only the first $1350 will be taxed at the student's tax rate.
But, the student may be eligible for some education credit, since he has some earned income and some taxable scholarship. A full time student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he/she supports himself by working. He cannot be supporting herself on student loans & grants and 529 plans and parental support. But, 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). The non refundable education credit can only be used against income tax ( cannot be used against the 10% penalty or self employment tax).
In order to free up some tuition, to claim for the education credit, he'll need to declare more of the scholarship as taxable income. See generic explanation below. Claiming a tuition credit is also an exception to the 10% penalty for a non qualified 529 distribution
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There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. 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.
Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he has $2000 of taxable income and nobody can claim the American opportunity credit. But if he reports $6000 as income on his 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, paid out of pocket. He would only need to report $5000 of taxable scholarship income, instead of $6000.
The IRS actually encourages use of this technique. From the form 1040 instructions: “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 and IRS.gov/EdCredit". PUB 970 even has examples of how to do the “loop hole”.
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Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $15,750 filing requirement (2025) 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.
