Q. Is 2nd option available to us, can he claim AOTC?
A. Yes, but only as a non-refundable credit. The credit can only be used to reduce an actual tax liability. He can only do so, if you do not claim him as a dependent (you won't get the $500 other dependent credit). He still indicates that he CAN be claimed as a dependent.
The math is similar, even if your numbers are different. It's a matter of allocating expenses for the best outcome. Using a different example:
$49,000 Scholarship
$45,000 529 Distribution
$63,000 Tuition and other Qualified educational expenses (QEE)
$18,000 room and board
Allocate $4000 QEE to the AOTC. That leaves $59, 000 (63,000 - 4000). That's enough to fully cover the scholarship and have $10,000 left over to allocate to the 529 distribution. $18,000 room and board + $10,000 QEE = $28,000 for the 529 distribution. That is less than the total $45K distribution. So, some of the distribution earnings will be taxable.
To reduce the taxable amount, you declare $11,350 of the scholarship to be taxable.* Now we have $18,000 + $10,000 QEE + $11,350 additional QEE = $39,350 to allocate to the 529 distribution. 39,350 / 45,000 =87.44% of the earnings are tax free. Only12.56% is taxable.
*$11,350 + $2500 wages = $13,850 standard deduction. None of the scholarship or wages get taxed.
