Q. TT will then take the $4000 out I am using for the credit?
A. Yes, it should. It will present you with a screen, "amount used to claim the education credit". Verify that $4000 was used or change it.
Q. TT will then take the $4000 out I am using for the credit, his tax will go up by the tax on the $4000 of unmatched 529 payments?
A. Not exactly, The tax is on a percentage of the box 2 earnings.
Example (slightly changed from the older example above):
$10,000 in educational expenses(including room & board)
-$3000 paid by tax free scholarship
-$4000 used to claim the American Opportunity credit
=$3000 Expenses that can be used against the 1099-Q (on the recipient’s return)
Box 1 of the 1099-Q is $5000
Box 2 is $2800
3000/5000=60% of the earnings are tax free; 40% are taxable
40% x 2800= $1120
There is $1120 of taxable income (on the recipient’s return)
The tax rate will depend on his other income and when and whether the "kiddie tax" kicks in. So, probably 10-12%.
Q. If I am mistaken with any of this, please let me know.
A. You're not mistaken. The difference between $2500 and the small amount of tax he pays, is not peanuts. But you haven't provided enough info to tell you if there is a better way. In particular, if your student has scholarship, is usually better to declare some of that scholarship taxable, rather than the 1099-Q earrings.
Another common issue: most people still have enough expenses, counting room & board, for the 1099-Q to be tax free even if claiming the AOC. In that case, the 1099-Q does not need to be entered.
Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $12,950 filing requirement and the dependent standard deduction calculation (earned income + $400). It is not earned income for the kiddie tax and other purposes (EIC. IRA contributions).
