Q1: Is it okay for my daughter to simply NOT report the 1099-Q and the 1098-T?
A1. Yes, if you know none of the 1099-Q is taxable. Both documents are only informational and there is no requirement to enter them on your tax return.
Q2: If so, does this pose a risk or raise a red flag with the IRS?
A2. No. When none of the 1099-Q is taxable, nothing about it is sent to the IRS with your tax return. The risk is the same either way.
Q3: Is this likely an error with TurboTax? Or, am I at fault by missing something in my data entry?
A3. I can't tell. You talking about her refund and total tax liability instead of concentrating on the 1099-Q calculation.
But, it does appear that a very small portion of the 1099-Q is taxable:
$26,083 (529 distribution) - $26,007 (QEE-qualified educational expenses) = $76 non qualified distribution.
76 / 26083 =0.29% of the earnings are taxable
0.0029 x $19,494 = $57 of taxable income. This should be showing on line 8z of Schedule 1. In addition to the tax, there will be a 10% penalty (0.10 x 57 = $6). The penalty shows on form 5329
Better yet, come up with $76 more expenses and do not enter the 1099-Q.
I assume you are not claiming the tuition credit because you income is too high. You do not have to forego claiming the credit just because all the expenses were paid by the 529 plan. Allocate $4000 of tuition to the credit and have the student pay more tax on the 529 earnings. Depending on your tax rate (the "kiddie tax" applies), the family comes out $1700 - $2100 ahead. The 10% penalty does not apply, because you claimed another tax attribute. Your daughter is not eligible for the AOTC on her return.*
*Technically, she can claim a nonrefundable credit, but that requires you to forgo claiming her as a dependent and the $500 dependent credit. The math doesn't work out in your case.
