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Education
Q. I'm wondering if this year we can claim the entire tuition and fees paid in spring and fall, including the $8000 that were paid by scholarships?
A. Yes. You may count payments made in and for the current tax year and for the 1st term of the following year. You may count tuition paid by scholarship, if the student claims the scholarship as income.
Q. I understand that the $8000 would be taxable, to the student, if the student is the recipient?
A. Any taxable scholarship is taxable to the student (never to the parent) regardless of who is recipient of the 529 distribution is.
Q. But there would be no penalty, for the 529 distribution?
A. Yes, that's correct. But there is no penalty on the $8000 distribution, whether or not the scholarship is taxable. By making the scholarship taxable, you avoid the tax on that much of the distribution (actually only the earnings portion of the $8000 is taxable).
Q. So what proof is required for the amount of the scholarships in 2025 to be withdrawn penalty-free?
A. None, at tax filing time. If you are "audited", the statements and 1098-T is all the proof you need.
Q. If the student claims the scholarships as income, and DOESN'T take a 529 withdrawal for the fall scholarship (which is being applied to the tuition, since she will be in off-campus housing), will she be able to count that $4000 toward the AOTC?
A. Yes. But, as you appear to already know, only for non refundable portion of the AOTC*. This is still worth up to $2500 because the AOTC shifts to all non refundable.
Q. Or is she better off taking both scholarship amounts ($4000/semester in 2025) from the 529 and we'll claim her as a dependent on our taxes (meaning we'll get a $500 credit) though does that mean that the taxes on the "unqualified" 529 distribution will be taxed at our rate?
A. Yes, a non-qualified distribution is subject to tax at the parent rate ("kiddie tax"). Which way is better depends on the numbers (% of distribution that is earnings, how much AOTC student will get, amount and type of income student has**). Yes, it's usually better to make the scholarship taxable, particularly if AOTC is allowed.
Q. Can we go back after graduation, and after paying off student loans, and close out the account without penalties by claiming scholarships awarded in 2024 and prior years? Or does the equivalent amount received in scholarships need to be withdrawn from a 529 each calendar year like qualified expenses are?
A. Simple answer: Yes, you can claim the scholarship penalty exception, after graduation. That said, be advised there's some disagreement on the subject. Pub 970 doesn't really say, but a conservative interpretation is that the distribution must be made in the same year that the scholarship paid for the tuition expense.***
*While technically there is a provision that allows your student-dependent to claim a federal tuition credit, from a practical matter it seldom works out. A full time student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he/she supports himself by working. She cannot be supporting herself on student loans & grants and 529 plans and parental support. It is usually best if the parent claims that credit.
If the student actually has a tax liability, there is a provision to allow him to claim a non-refundable tuition credit. But then the parent must forgo claiming the student as a dependent, and the $500 other dependent credit. The student must still indicate that he can be claimed as a dependent, on his return. This is worth up to $2500 (AOTC shifts to all non refundable).
**Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024, $15,750 in 2025) and the dependent standard deduction calculation (earned income + $450). It is not earned income for the kiddie tax and other purposes (e.g. EIC). For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.
Taxable scholarship goes on line 8r of Schedule 1, from which TT treats it as hybrid income.
*** References:
https://www.forbes.com/sites/josephhurley/2016/02/04/dont-make-these-mistakes-when-reporting-529-pla... This one says you can claim the exception anytime, after graduation
529 Scholarship exception year 529 year. Peter J. Greco, CPA, founder and chief tax strategist at the CSI Group, believes you have more latitude when deciding when to take the scholarship distribution. “Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense,” Greco says. “However, IRS 970 is silent as to when the money must be withdrawn. If Congress is trying to encourage 529 plans, then it makes good policy sense that the withdrawals can be made any time prior to graduation.”
https://www.investopedia.com/news/penaltyfree-way-get-529-money-back/
