In late January, you will get a form 1099-Q from the 529 plan administrator. Box 1 will show $25,000. Box 2 will show the earnings portion of that $25K.
Here's how it works::
He declares $11,350 (13,850 - 2500 = 11,350) of his scholarship as income*. That means that only $13,650 ($25,000 - 11,350 = 13,650) of his scholarship was allocated to expenses (or $13,650 of expenses was allocated to scholarship). That means that $11,350 of the 529 distribution can be allocated to educational expenses (or $11,350 of expenses are allocated to the 529 distribution) and is therefore a qualified distribution. That means that $13,650 of the distribution is non-qualified.
13,650 / 25,000 = 54.6% of the distribution is non-qualified. That mean that 54.6% of the earnings shown in box 2 of the 1099-Q are taxable income to the recipient. The taxable portion qualifies for the scholarship exception to the 10% penalty. TurboTax (TT) is capable of doing all that, but it can get tricky. It helps if you have some idea of the expected output.
If the reason you are not claiming him as a dependent is so that he can claim the education credit, then we need to allocate expenses differently. You'll need $4000 of expenses for the AOTC. Room & board are qualified expenses for a 529 distribution but not for the AOTC or tax free scholarship*. That means that $10,000 should now be allocated to the 529 distribution and is a qualified distribution. That means that $15,000 of the distribution is now non-qualified. 15,000 / 25,000 = 60% of the distribution is non-qualified and 60% of the box 2 earnings is taxable. The taxable earnings qualify for the scholarship and tuition credit exceptions to the 10% penalty. But, the amount of taxable scholarship has to increase to $14,000. There is only $15,000 of qualified expenses, not counting room and board. $4,000 is used for (allocated to) the AOTC. That leaves $11,000 for the scholarship. $25,000 -11,000 = $14,000 taxable. The AOTC should wipe out most of the tax. The "kiddie tax" most likely will apply.
Q. But we only have to pay taxes on income earned, right?
A. No. Part of the scholarship and part of the earnings portion of the 529 distribution will be taxable, as well as his wage earnings.
Q. Can we claim the entire $25K withdrawal/distribution from 529 as his earned income?
A. No. Taxable 529 distributions are unearned income. The whole $25K is not income, only the earnings portion. And then, only a calculated portion of the earnings.
Q. What are the benefits of reallocating funds as earned income vs paying taxes on income earned on $25K?A. Explained above. It's more a matter of allocating expenses, rather than allocating funds. Allocating some expenses to the AOTC gets you an (up to) $2500 tax credit. Allocating expenses to the 529 distribution reduces the amount of unearned income taxed. Allocating expenses away from the scholarship (and making some of the scholarship taxable) gets you a larger standard deduction.
*Note that R&B are not qualified expenses, for tax free scholarship. So, $10,000 of the $25,000 scholarship was always going to be taxable.
