Q. Report that $12600* of the Scholarship was spent on Room and Board Expense (making it taxable)
Report that $24400 of it was spent on Tuition?
A. Basically yes. But more specifically, you're just saying that much of the scholarship is not being allocated to tuition. Note that the entry, in TurboTax, for allocating the scholarship to R&B says “or other expenses”. You didn’t have to literally use the scholarship for R&B.
Q. Is it really allowed to shift the expenses like that to avoid tax on part of the non qualified 529 distribution (application of the kiddie tax is an off shoot of the taxability of the distribution)?
A. Yes. The IRS actually encourages use of this technique, allowing parents to claim a tuition credit. From the form 1040 instructions: “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040 and IRS.gov/EdCredit". PUB 970 even has examples of how to do the “loop hole”. The same principal applies whether shifting the expenses to a credit or the 529 distribution. You cannot use this "loop hole" if the conditions of the scholarship are that it must be used for tuition.
* Actually only $12,150 (12,600 -450). A dependent's standard deduction is her earned income + $450, but not more than $14,600. Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement and the dependent standard deduction calculation (earned income + $450 for 2024). It is not earned income for the kiddie tax other purposes (e.g. EIC).
