Sorry for the late reply! I couldn't get back to this return until today. Thank you so much for another detailed response!
Thanks to you and others from past posts on this forum, I think I have finally wrapped my head around all this. After looking back at your first response and the 3,869 number, I understood that anything that was not paid out-of-pocket has to be taxable to add up to the $4000 claimed for the AOTC. After playing around with 3,869 taxable scholarship vs. split between 529 and scholarship, it's clear that claiming the full amount as taxable scholarship is the best route to go since it's calculated as earned income and her taxes due still do not change. I will need to file an amended state return, but taxes are minimal even with interest and penalties.
For any parents dealing with this in the future, it really pays to spend time to understand the underlying formulas to determine taxable earnings on the 529 withdrawals and the tax ramifications of claiming taxable scholarships (earned income) vs taxable 529 distributions (unearned income). Overall TurboTax does a good job, but when you get to these more complex education situations it's a little bit too dumbed down in my opinion. Some of the questions are a bit vague or confusing and they can really have an impact on your taxes if you don't know exactly what the numbers should be. I learned from this forum that there are various ways you can enter your 1099-Q and 1098-T data and you really have to look at the underlying forms as you make changes. Once I knew the funds I wanted to claim as taxable, I needed to check the forms to make sure what I entered on the front end of TurboTax reflected what I wanted on the tax forms. Specifically, you're dealing with taxable scholarship amounts being reflected on line 1 of the 1040 tagged with "SCH xxx" to indicate the amount of scholarship claimed, Form 5329 which shows taxes on earnings from 529 distributions, and possibly Form 8615 which calculates the kiddie tax for any unearned income taxed at the parent's marginal income tax rate.
I would be nice if the government could find a way to just give these credits to those families that qualify rather than require all the mental gymnastics. I know it's an optional credit, but I can't think of a scenario where a family or student that were eligible would NOT want to claim these tax credits.
Good luck to other parents jumping through these tax hoops. Make sure you have a stiff drink on hand for when you are finished!
