Q. My son's tuition and fees bill is 9000. Of that, 7,000 is paid with a non taxable scholarship. The remaining 2,000 were paid off with the 10,000 529 distribution (the other 8,000 of the distribution was used for room and board). we ARE claiming the AO credit as well. So a portion of the 2k earnings has to be taxable, yes?
A. Simple answer: yes. If $4000 of expenses are used to claim the AOC, that's 4000 of expenses no longer available for the 1099-Q (529 distribution) and/or tax free scholarship.
But you get to allocate those expenses. If the scholarship is not restricted to tuition, it is usually better to declare $4000 of the scholarship as taxable, rather than paying tax on the 1099-Q. You're thinking "How is paying tax on $4000 better than paying tax on $2000?" Taxable scholarship is "earned income" and the student-dependent gets a bigger standard deduction for that. So, if that is his only income, no tax is due. Technically, he doesn't even have to file a tax return. But, you may want to do so, to document that he declared it taxable.
If the scholarship is restricted, and you can't shift tuition from it to the AOC; your numbers, limit you to only using $2000 of tuition (9000 - 7000 = 2000) for claiming the AOC (you get a$2000 credit, rather than the full $2500).
If only $2000 of expenses are used to claim the AOC, that's 2000 of expenses no longer available for the 1099-Q (529 distribution). So, 2000 of the 10,000 distribution is not longer "qualified". 2000 / 10,000 = 20%. 20% of the $2000 earnings is taxable. 0.20 x $2000 =$400 of taxable income goes on the student's return. If that's his only income he does not need to file since it is less than the $1100 filing requirement for unearned income.
