Q. Since the 529 has paid for her expenses, she has arguably paid more than half of her own expenses, hence could be considered independent, right?
A. No (more accurately, probably No). The treatment of expenses paid with distributions from Sec. 529 plans and Coverdell ESAs in the support test is uncertain because of the dual nature of these college savings vehicles and a lack of IRS guidance. The consensus among tax experts is that it is parental support, because the parent is the owner of the plan.
References: https://www.savingforcollege.com/articles/the-impact-of-529-plans-on-claiming-a-dependent
https://proconnect.intuit.com/community/tax-talk/discussion/529-plan-distribution-and-support-test/0...
Q. If she is NOT my dependent, the AOTC will go on her tax return (instead of mine) and hence a refund to her. Right?
A. No. A full time unmarried student, under age 24, even if she doesn't qualify as a dependent, is only eligible for the refundable portion of the American Opportunity Credit if she supports herself by working. She cannot be supporting herself on parental support, 529 plans or student loans & grants. It is usually best if the parent claims that credit. If she has an actual tax liability, she is allowed to claim the non refundable AOTC, up to the full $2500 (the refundable portion switches to non refundable).
Q. Am I allowed to NOT claim her as my dependent?
A. Yes. But, she is still not allowed to "claim herself". In particular, this means no refundable AOTC. She doesn't automatically get a full $13,850 standard deduction (2023). You lose the $500 Other dependent credit.
Q. Other suggestions?
A. She can declare some/more of her scholarship as taxable, making less of the 529 distribution taxable. Non qualified 529 distributions are unearned income.
Taxable scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement (2023) and the dependent standard deduction calculation (earned income + $400, up to $13,850). It is not earned income for the kiddie tax and most other purposes (e.g. AOTC).
