Q. So why is it generating taxable other income if the scholarship is supposed to be "tax free"?
A. Because the scholarship is only tax free if it is used to pay qualified expenses (tuition, fees, books and a computer, but not room and board). So, the amount of qualified expenses for the 529 distribution has to be reduced by the amount paid by scholarship. Note that TT will deduct the box 5 amount from the box 1 amount when calculating/allocating expenses.
TurboTax (TT) is doing it correctly; $4668 is the taxable amount of the distribution, based on the numbers you input.
Your own calculations verify this. $19,068 of qualified expenses (18843 + 225 = 19068) less $8500 paid by tax free scholarship, less $4000 used for the American Opportunity Credit = $6568 of adjusted qualified expenses for the 529 distribution. 6568/18784=34.97% of the earnings are tax free; 65.03% are taxable. 0.6503 x $7178 = $4668..
Three seems to be some question as to the accuracy of your numbers. Room and board should not be in box 1 of the 1098-T. Although it has been known to happen, the school should know better. You should review your billing statements. It appears that you should be entering room and board expenses in addition to the 1098-T. The fact that you say you paid $18,784 out of pocket supports that. In addition, don’t ignore book and computer expenses just because you didn’t include them in your 529 distribution. They can still be used to reduce the taxable portion.
Since the student only has $4000 of income, you also have the option of him reporting some or all of the $8500 as taxable scholarship income. This will free up $8500 of expenses for the 529 distribution. He will still pay no tax because taxable scholarship is treated as earned income for the calculation of a student’s standard deduction.
