Q. This $3,068 is taxable income to report. As you mentioned last time, “None will be subject to the 10% non-qualified distribution penalty because the non-qualified portion of distribution was used to claim a credit”. Is this still the case?
A. Yes and your numbers appear to be correct.
Before we get into the details of how to enter all that (and it will be complicated). There's a better way, if the terms of her scholarship are not restricted to paying tuition. She can declare $4000 of her scholarship to be taxable income*. That allows you to use $4000 for the AOTC and all the other expenses to be fully used to cover the 529 distribution. The 1099-Q doesn't have to be entered. You save money and entry in TT goes easier.
Q. How is having $4000 taxed better than having $3068 taxed?
A. Taxable scholarship is considered earned income for purposes of calculating a dependent's standard deduction (earned income + $400 but not more than $12,950). Taxable 529 earnings is considered unearned/investment income. Her standard deduction is limited to $1150 and the income is subject to the "kiddie tax" (taxed at the parent's marginal rate). In other words, if she has no other income (or about $2,816) the scholarship goes untaxed, but the 529 would be taxed.
*From the form 1040 instructions: “You may be able to increase an education credit [or 529 plan exclusion] if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040 and IRS.gov/EdCredit". PUB 970 even has examples of how to do this “loop hole”.
I have not reviewed your "1099-Q Comments:" yet.
