Q. Do I enter the difference of $27,958 on her return as income?
A. Yes. You may reduce that amount by any book and computer expenses, or other course materials.
Q. Would I be able to claim $31,958 as income on my daughter's return and then claim $4,000 for the AOC on mine?
A. Yes.
Q. My understanding is that she doesn't have to report the 1099-Q if no credit is claimed.
A. Not exactly. She does not have to report the 1099-Q if you know that none of it is taxable (the distribution amount is fully covered by expenses). If shifting some of the tuition expenses to the AOC means that there are no longer enough expenses for the 1099-Q, then some of the 529 plan earnings will be taxable. But, that's unlikely because you are going to reallocate expenses away from the scholarship instead. You don't need to reallocate any of the 1099-Q expenses. Room & board are only qualified expenses for the 1099-Q, not the tuition credit or for the scholarship to be tax free.
You actually have a situation* where it is better to re-allocate expenses from the 1099-Q to the AOC, rather than from the scholarship to the AOC. All $4000 of the scholarship income is taxable; while only a percentage of the 1099-Q amount will be.
Example:
$11,000 in educational expenses
-$4000 allocated to tax free scholarship
-$4000 used to claim the American Opportunity credit
=$3000 Can be used against the 1099-Q (on the recipient’s return)
Box 1 of the 1099-Q is $5000
Box 2 is $2800
3000/5000=60% of the earnings are tax free; 40% are taxable
40% x 2800= $1120
There is $1120 of taxable income (on the recipient’s return)
*The amount of taxable scholarship she has is already more than the maximum standard deduction. Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024) and the dependent standard deduction calculation (earned income + $450). It is not earned income for the kiddie tax and other purposes (e.g. EIC).
