Both are correct.
You will claim the 4,000 for a credit.
Your Mother-in-law pays no tax on the distribution since it was used for education expenses.
HOW IT IS SUPPOSED TO WORK-
Student is beneficiary, student makes distribution, student receives 1099-Q and 1098-T.
If student is dependent, person claiming student gets a credit if expenses are more than assistance and student pays the tax if expenses are less.
If student is not dependent, student gets a credit if expenses are more than assistance and student pays the tax if expenses are less.
Since the student is not a dependent, and since the account owner (not the student) took the distribution, the person issued the 1099-Q needs to co-ordinate with the student so that the student lowers the amount of expenses they claim for an education credit.
1099-Q and 1098-T are INFORMATIONAL forms. The IRS does get copies, but they are not LISTED on a return. The numbers are used to calculate a credit and/or taxable income.
In TurboTax, and in your situation, your mother-in-law may simply not enter the 1099-Q, or enter the 1099-Q and select the option that it was used for education purposes for someone not listed as a dependent. The program will tell her that it isn't taxable and that will be the end of it.
In TurboTax, you (filing with the student) must lower the amount in Box 1 by the amount of the distribution, OR enter the 1098-T as is, and then report the distribution as additional aid received.
Either way, the numbers come out the same. Mother-in-law has no tax on the distribution and you use the lower expense amount towards a credit.
Transferring funds to the school directly will result in the student getting the 1099-Q which is how it should work and makes tax filing so much easier.
IRS Pub 970 explains in detail.
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