Q. If I've understood correctly, I either have to choose between the $2500 American Opportunity Credit (AOC) credit OR not paying taxes on the earnings from the 529 plan (1099-Q). Is that correct?
A. Yes, basically. But not exactly.
The first decision is easy, you do claim the AOC. It's too generous to pass up, if you qualify (your income is not too high). It only takes $4000 of tuition to qualify for the maximum $2500 AOC.
Then you reduce the expenses you use for the 1099-Qs. You will pay tax on only some of the 529 earnings.
You also have to reduce the expenses you use for the 1099-Q by the amount of the scholarship.
So, you need to allocate expenses to the 3 tax attributes (AOC, 529, scholarship). That gets tricky in TurboTax (TT), so I recommend short cuts. Do you have any book and computer expenses, in addition to the above? That would reduce the taxable amount.
Do not enter your 1099-Q because it's covered by $700 of room and board, we'll allocate to it.
Enter the 1098-T on your return with $4000 in box 1 and box 5 blank (this is allowed).
So, you've allocated $4000 of tuition to the AOC and $700 of R&B to your 1099-Q. That leaves $7000 R&B and $4100 tuition for her ($11,100 total expenses). $1250 (tuition) is allocated to the scholarship, leaving $9850 for her 1099-Q. 9850 / 14,500 = 67.93% of the earnings are not taxable. 32.07% is taxable. $5300 x 0.3207 = $1700 reportable income. She gets a $1300 standard deduction (assuming she has no other income). So, $400 of taxable income.
Again, I recommend a short cut*. Enter her 1099-Q on her return. When asked who the student is answer: someone else not listed here (lying to TurboTax to get it to do what you want does not constitute lying to the IRS). Enter the student's name when asked. At the 1099-Q screen, do check the box "the recipient is not the designated beneficiary". A few screens later, you'll get one simple screen to enter expenses ($8100 tuition & $7000 R&B). Press Done at the 1099-Q summary screen, to get there. Also enter the $5250 (1250 + 4000) in the box "Tax-free assistance". This reports the earnings as taxable and claims the scholarship/tuition credit exception. You do not have to deal with the complicated “Educational expenses and Scholarships” (1098-T) section later. TT will prepare form 5329 to claim the penalty exception.
*TT can theoretically handle it if you enter the 1099-Q correctly and then later enter the expenses in the 1098-T section, with adjustments, but it doesn't always come out right. So, yes, the 1098-T would normally go on both the student's and parent's returns.
