Q. So don't we owe taxes on the earnings portion ($3486 ) of the $7395?
A. No, because we have chosen to make the scholarship taxable*, instead of the 529 distribution, by the allocation of expenses. I have assumed the scholarship is not restricted to tuition (most are not).
You're getting bogged down in details of trying to match expenses to specific payments. That's not required. It doesn't matter what funds actually paid for which expense.
You don't allocate the money sources, you only allocate the expenses. There are three things you can do with your Qualified educational expenses (QEE):
- Use them to claim an education credit
- Allocate them to the 529 distribution (1099-Q) so that it will not all be taxable
- Allocate them to scholarships (so that the scholarship remains tax free)
You don't have sufficient expenses to make both the scholarship and the 1099-Q tax free. So, we allocate the expenses for the best tax effect. As a result, the student needs to declare $3544 of scholarship as income. But, you get to claim the AOC and the 1099-Q is tax free (and not reported).
*You want the scholarship to be taxable before the 529 earnings because taxable scholarship is treated as earned income while the 529 is unearned income. A dependent's standard deduction is calculated on his earned income, so effectively less income is subject to actual tax.
