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529 Distribution to match 2023 scholarship went thru in January 2, 2024

We initiated a withdrawal to match the scholarship money our son got for 2023 on Dec 28, 2023. It was processed on January 2, 2024. We requested the money to be paid to him. Can he declare those as income in 2023 to avail of AOTC?

 

If we can't use it in 2023, can we withdraw the same amount in 2024 and use scholarships received in 2023 and 2024 to waive the 10% penalty?  Our question is can we waive the 10% tax penalty on the January 2024 disbursement meant for the 2023 scholarship received, when we file taxes in 2024 (which would allow us to withdraw the 2024 scholarship received penalty-free as well)?

 

 

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Accepted Solutions
Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. This distribution is meant to cover scholarship money my son received (not qualified expenses). Will there be an issue if we report the distribution processed on Jan 2, 2024, on our son's 2023 returns (the check written to him)?

A. No. More accurately, probably not. As explained above, we don't know, for sure, what the IRS's attitude is on this timing issue.  Your son is more likely to hear form the IRS for not reporting the distribution on his 2024 return, because that is the year for which the 1099-Q will be issued.  Even then, it's unlikely and easily explained, particularly since you can point out that it was reported on his 2023 return.

 

Be forewarned, this can get a little tricky, entering it into TurboTax.  Be sur you enter the  529 distribution (at the 1099-Q screen even though you did not actually get a 1099-Q), before you enter the 1098-T.  TT needs to  prepare form 5329 to claim the penalty exception. 

 

Another option is for him to declare some of the scholarship as taxable income, so that the 529 distribution (or some of it) can be tax free. Non qualified 529 distributions are unearned income. 

Taxable scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement (2023) and the dependent standard deduction calculation (earned income + $400, up to $13,850).  It is not earned income for the kiddie tax and most other purposes (e.g. AOTC).  

 

Q. Can he declare those as income in 2023 to avail of AOTC?

A. No.  Neither scholarships or 529 distributions are "earned income"  for purposes of the AOTC.  

A full time unmarried student, under age 24, even if you don't qualify as a dependent, is only eligible for the refundable portion of the American Opportunity Credit if more than half his support comes from his own earned income. You cannot be supporting yourself on parental support, 529 plans or student loans & grants. It is usually best if the parent claims that credit. 

View solution in original post

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. So I can declare up to $13,850 as taxable income?

A. Yes, a student dependent will get a full $13,850 standard deduction if he has $13,450 or more of earned income, including taxable scholarship.  If his total income is less than $13,850, he will owe no tax.

 

Q. He received about $2500 from a part-time job over the summer do I deduct that amount from $13,850? 

A. Yes.  He would declare only (up to) $11,350 of his scholarship taxable, unless he had more taxable 529 earnings to offset.   Note that only the earnings portion of a 529 distribution is taxable.  See example below. 

 

P.S. Re-read my last reply. My edit may have occurred shortly after you read it. 

___________________________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The American Opportunity Credit (AOC or AOTC) is 100% of the first $2000 of tuition and 25% of the next $2000 ($2500 maximum credit). The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

 

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by 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)

 

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution.

View solution in original post

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

In late January, you will get a form 1099-Q from the 529 plan administrator.  Box 1 will show $25,000. Box 2 will show the earnings portion of that $25K. 

Here's how it works::

He declares  $11,350 (13,850 - 2500 = 11,350) of his scholarship as income*.  That means that only $13,650 ($25,000 - 11,350 = 13,650) of his scholarship was allocated to expenses (or $13,650 of expenses was allocated to scholarship). That means that $11,350 of the 529 distribution can be allocated to educational expenses (or $11,350 of expenses are allocated to the 529 distribution) and is therefore a qualified distribution.  That means that $13,650 of the distribution is non-qualified. 

13,650 / 25,000 = 54.6% of the distribution is non-qualified. That mean that 54.6% of the earnings shown in box 2 of the 1099-Q are taxable income to the recipient. The taxable portion qualifies for the scholarship exception to the 10% penalty.  TurboTax (TT) is capable of doing all that, but it can get tricky. It helps if  you have some idea of the expected output.

 

If the reason you are not claiming him as a dependent is so that he can claim the education credit, then we need to allocate expenses differently.  You'll need $4000 of expenses for the AOTC.  Room & board are qualified expenses for a 529 distribution but not for the AOTC or tax free scholarship*. That means that $10,000 should now be allocated to the 529 distribution  and is a qualified distribution.  That means that $15,000 of the distribution is now non-qualified. 15,000 / 25,000 = 60% of the distribution is non-qualified and 60% of the box 2 earnings is taxable.  The taxable earnings qualify for the scholarship and tuition credit exceptions to the 10% penalty.  But, the amount of taxable scholarship has to increase  to $14,000. There is only $15,000 of qualified expenses, not counting room and board. $4,000 is used for (allocated to) the AOTC. That leaves $11,000 for the scholarship. $25,000 -11,000 = $14,000 taxable. The AOTC should wipe out most of the tax.  The "kiddie tax" most likely will apply. 

 

Q. But we only have to pay taxes on income earned, right?

A. No. Part of the scholarship and part of the earnings portion of the 529 distribution will be taxable, as well as his wage earnings.

 

Q. Can we claim the entire $25K withdrawal/distribution from 529 as his earned income?

A. No. Taxable 529 distributions are unearned income. The whole $25K is not income, only the earnings portion. And then, only a calculated portion of the earnings.

 

Q. What are the benefits of reallocating funds as earned income vs paying taxes on income earned on $25K?A. Explained above. It's more a matter of allocating expenses, rather than allocating funds. Allocating some expenses to the AOTC gets you an (up to) $2500 tax credit. Allocating expenses to the 529 distribution reduces the amount of unearned income taxed. Allocating expenses away from the scholarship (and making some of the scholarship taxable)  gets you a larger standard deduction.

 

 

*Note that R&B are not qualified expenses, for tax free scholarship. So, $10,000 of the $25,000 scholarship was always going to be taxable.

 

View solution in original post

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. Is 2nd option available to us, can he claim AOTC? 

A. Yes, but only as a non-refundable credit. The credit can only be used to reduce an actual tax liability.  He can only do so, if you do not claim him as a dependent (you won't get the $500 other dependent credit). He still indicates that he CAN be claimed as a dependent.

 

The math is similar, even if your numbers are different. It's a matter of allocating expenses for the best outcome. Using a different example:

$49,000 Scholarship

$45,000 529 Distribution

$63,000  Tuition and other Qualified educational expenses (QEE)

$18,000 room and board

 

Allocate $4000 QEE to the AOTC.  That leaves $59, 000 (63,000 - 4000). That's enough to fully cover the scholarship and have $10,000 left over to allocate to the 529 distribution.  $18,000 room and board + $10,000 QEE = $28,000 for the 529 distribution. That is less than the total $45K distribution. So, some of the distribution earnings will be taxable. 

 

To reduce the taxable amount, you declare $11,350 of the scholarship to be taxable.*  Now we have $18,000 + $10,000 QEE + $11,350 additional QEE = $39,350 to allocate to the 529 distribution.  39,350 / 45,000 =87.44% of the earnings are tax free. Only12.56% is taxable. 

 

 

*$11,350 + $2500 wages = $13,850 standard deduction. None of the scholarship or wages get taxed. 

 

View solution in original post

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. With these numbers, it makes more sense to claim AOTC, right?

A.  Good question. Maybe not.  It depends on the 529 plan earnings.

 

Using an example, let's say $30,000 of that $45,000 distribution was earnings. 12.56% x $30,000 = $3768 taxable income. Not using the AOTC results in about $1100 taxable income ($4000 more QEE allocates to the distribution).  You're only saving about $100, in tax, by using the AOTC.   You only get to use the AOTC 4 times in the student's undergrad years.  If this situation continues for 3 more years, you may not see much benefit from the AOTC.  But, if that's all you can get, there's no need to save the AOTC for later. It's better if the parents can use it.

 

What if you use the Lifetime Learning Credit (LLC) instead. $6000 more will be allocated to the tuition credit, meaning $6000 less goes to the 529 distribution.  $39,350 -6000 = 33,350.  33,350 / 45,000 = 74.1% . 25.9% of the 529 earnings portion is taxable. 25.9% x $30,000 = $7767 taxable income.  Even if taxed at 22%, the tax should be wiped put by  the LLC (maximum $2000).

 

You want to consider using the download version of TurboTax, rather than the online versions. You can do multiple trial returns to see which gives you the best result. 

View solution in original post

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. With such small earnings from the distribution does it still make sense to claim AOTC or LLC?

A.  Probably not. 12.5% of $2000 = $250 taxable income = about $25 tax.  Shifting $4000 QEE to the distribution makes it even less. 

View solution in original post

30 Replies

529 Distribution to match 2023 scholarship went thru in January 2, 2024

I'll page Champ @Hal_Al 

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Technically, a 529 distribution must occur in the same year the expenses were paid.  This problem, of mismatched year end distributions, is fairly common.  Treat it as received in 2023 and  hope you can explain it away if you receive an IRS notice (unlikely).   You certainly meet  the intent of the 529 rules, if not the strict letter.  We haven't seen any reports, in this forum, of how that specific problem  has actually worked out. But, this is the usual advice. 

 

Do a better job on timing next year

 

Several users have reported receiving a CP2000 letter, from the IRS,  on unreported 529 distributions. They replied that their child was in college and the distributions were used for qualified expenses, which they listed, but they did not provide receipts. Others have reported just sending copies of the school's billing statements. They  later received a notices saying they were in the clear. I've noticed a significant drop in users, here,  reporting IRS notices about 1099-Qs, in the last two years.

 

More info: https://www.savingforcollege.com/article/timing-of-529-plan-distributions-must-match-qualified-expen...

529 Distribution to match 2023 scholarship went thru in January 2, 2024

This distribution is meant to cover scholarship money my son received (not qualified expenses). Will there be an issue if we report the distribution processed on Jan 2, 2024, on our son's 2023 returns (the check written to him)?

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. This distribution is meant to cover scholarship money my son received (not qualified expenses). Will there be an issue if we report the distribution processed on Jan 2, 2024, on our son's 2023 returns (the check written to him)?

A. No. More accurately, probably not. As explained above, we don't know, for sure, what the IRS's attitude is on this timing issue.  Your son is more likely to hear form the IRS for not reporting the distribution on his 2024 return, because that is the year for which the 1099-Q will be issued.  Even then, it's unlikely and easily explained, particularly since you can point out that it was reported on his 2023 return.

 

Be forewarned, this can get a little tricky, entering it into TurboTax.  Be sur you enter the  529 distribution (at the 1099-Q screen even though you did not actually get a 1099-Q), before you enter the 1098-T.  TT needs to  prepare form 5329 to claim the penalty exception. 

 

Another option is for him to declare some of the scholarship as taxable income, so that the 529 distribution (or some of it) can be tax free. Non qualified 529 distributions are unearned income. 

Taxable scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement (2023) and the dependent standard deduction calculation (earned income + $400, up to $13,850).  It is not earned income for the kiddie tax and most other purposes (e.g. AOTC).  

 

Q. Can he declare those as income in 2023 to avail of AOTC?

A. No.  Neither scholarships or 529 distributions are "earned income"  for purposes of the AOTC.  

A full time unmarried student, under age 24, even if you don't qualify as a dependent, is only eligible for the refundable portion of the American Opportunity Credit if more than half his support comes from his own earned income. You cannot be supporting yourself on parental support, 529 plans or student loans & grants. It is usually best if the parent claims that credit. 

529 Distribution to match 2023 scholarship went thru in January 2, 2024

So I can declare up to $13,850 as taxable income? He received about $2500 from a part-time job over the summer do I deduct that amount from $13,850? 

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. So I can declare up to $13,850 as taxable income?

A. Yes, a student dependent will get a full $13,850 standard deduction if he has $13,450 or more of earned income, including taxable scholarship.  If his total income is less than $13,850, he will owe no tax.

 

Q. He received about $2500 from a part-time job over the summer do I deduct that amount from $13,850? 

A. Yes.  He would declare only (up to) $11,350 of his scholarship taxable, unless he had more taxable 529 earnings to offset.   Note that only the earnings portion of a 529 distribution is taxable.  See example below. 

 

P.S. Re-read my last reply. My edit may have occurred shortly after you read it. 

___________________________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The American Opportunity Credit (AOC or AOTC) is 100% of the first $2000 of tuition and 25% of the next $2000 ($2500 maximum credit). The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

 

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by 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)

 

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution.

529 Distribution to match 2023 scholarship went thru in January 2, 2024

I think I'm overcomplicating this.  Of the $25,000 529 distribution we got to match our son's scholarship money, I understand we only have to taxes on income earned (no 10% penalty). Does it matter how we allocate the $25K withdrawal we got (qualified vs non-qualified expenses)?

 

What's the benefit of declaring part of the scholarship money as earned income? Can we still declare scholarship money we got a 529 withdrawal match as our son's earned income? 

 

My wife and I are making too much to qualify for AOTC.  My son is a full-time student who received about $2500 from his summer job, so I don't think he'll qualify as well.

 

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Restating the facts, for clarification.:

He got $25K scholarship

He took a $25K distribution from his 529 plan (he was the recipient)

He had $10K room & board (R&B)

He had $ 15K tuition, fees and other qualified expenses (books & course materials including a computer)

He had $2500 earned income

Is that correct?

 

Q. The $15K distribution used to pay for qualified expenses, should be tax-free and penalty-free. Am I correct?

A. No. It appears it was covered by scholarship. 

But you can re-allocate funds and expenses as needed.

 

Q. Can we only declare earned income on the scholarship amount we did not get 529 distribution?

A. No, you can re-allocate funds and expenses as needed.

 

Are you  eligible for the AOTC (is your income not too high)?

Is any of the scholarship restricted? That is, must it be used for certain expenses (usually tuition)?

Is the student your dependent?

I assume the student is a full time undergrad.

 

 

 

529 Distribution to match 2023 scholarship went thru in January 2, 2024

All facts you re-stated are correct. 

 

RE:

Q. The $15K distribution used to pay for qualified expenses, should be tax-free and penalty-free. Am I correct?

A. No. It appears it was covered by scholarship. 

Withdrawals/distributions from 529 to match the scholarship amount received are NOT subject to a 10% penalty, but we still have to pay taxes on earnings (interest).  

 

Q. Can we only declare earned income on the scholarship amount we did not get 529 distribution?

A. No, you can re-allocate funds and expenses as needed.

Can we claim the entire $25K withdrawal/distribution from 529 as his earned income?  What are the benefits of reallocating funds as earned income vs paying taxes on income earned on $25K? 

 

Are you  eligible for the AOTC (is your income not too high)?  

No, my wife and I do not qualify.

 

Is any of the scholarship restricted? That is, must it be used for certain expenses (usually tuition)?

The scholarship received has no restrictions.

 

Is the student your dependent?

Yes, but we're planning not to claim him.

 

I assume the student is a full time undergrad.

Yes, he is a full-time undergrad.

 

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

In late January, you will get a form 1099-Q from the 529 plan administrator.  Box 1 will show $25,000. Box 2 will show the earnings portion of that $25K. 

Here's how it works::

He declares  $11,350 (13,850 - 2500 = 11,350) of his scholarship as income*.  That means that only $13,650 ($25,000 - 11,350 = 13,650) of his scholarship was allocated to expenses (or $13,650 of expenses was allocated to scholarship). That means that $11,350 of the 529 distribution can be allocated to educational expenses (or $11,350 of expenses are allocated to the 529 distribution) and is therefore a qualified distribution.  That means that $13,650 of the distribution is non-qualified. 

13,650 / 25,000 = 54.6% of the distribution is non-qualified. That mean that 54.6% of the earnings shown in box 2 of the 1099-Q are taxable income to the recipient. The taxable portion qualifies for the scholarship exception to the 10% penalty.  TurboTax (TT) is capable of doing all that, but it can get tricky. It helps if  you have some idea of the expected output.

 

If the reason you are not claiming him as a dependent is so that he can claim the education credit, then we need to allocate expenses differently.  You'll need $4000 of expenses for the AOTC.  Room & board are qualified expenses for a 529 distribution but not for the AOTC or tax free scholarship*. That means that $10,000 should now be allocated to the 529 distribution  and is a qualified distribution.  That means that $15,000 of the distribution is now non-qualified. 15,000 / 25,000 = 60% of the distribution is non-qualified and 60% of the box 2 earnings is taxable.  The taxable earnings qualify for the scholarship and tuition credit exceptions to the 10% penalty.  But, the amount of taxable scholarship has to increase  to $14,000. There is only $15,000 of qualified expenses, not counting room and board. $4,000 is used for (allocated to) the AOTC. That leaves $11,000 for the scholarship. $25,000 -11,000 = $14,000 taxable. The AOTC should wipe out most of the tax.  The "kiddie tax" most likely will apply. 

 

Q. But we only have to pay taxes on income earned, right?

A. No. Part of the scholarship and part of the earnings portion of the 529 distribution will be taxable, as well as his wage earnings.

 

Q. Can we claim the entire $25K withdrawal/distribution from 529 as his earned income?

A. No. Taxable 529 distributions are unearned income. The whole $25K is not income, only the earnings portion. And then, only a calculated portion of the earnings.

 

Q. What are the benefits of reallocating funds as earned income vs paying taxes on income earned on $25K?A. Explained above. It's more a matter of allocating expenses, rather than allocating funds. Allocating some expenses to the AOTC gets you an (up to) $2500 tax credit. Allocating expenses to the 529 distribution reduces the amount of unearned income taxed. Allocating expenses away from the scholarship (and making some of the scholarship taxable)  gets you a larger standard deduction.

 

 

*Note that R&B are not qualified expenses, for tax free scholarship. So, $10,000 of the $25,000 scholarship was always going to be taxable.

 

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Thank you so much! It's a little confusing but I have a much better idea.

 

Is 2nd option available to us? Can he claim AOTC?  We intentionally withdrew $4K less than the scholarship money he got because we intended to claim AOTC for him. 

Scholarship money received $29K.

529 disbursement to match scholarship $25K.

529 Distribution to match 2023 scholarship went thru in January 2, 2024

re: In late January, you will get a form 1099-Q from the 529 plan administrator.  Box 1 will show $25,000. Box 2 will show the earnings portion of that $25K. 

 

I won't get a 1099-Q because the disbursement was finalized on Jan 2, 2024 (although I initiated the withdrawal on Dec 29, 2023).

 

I have the withdrawal records showing how much the earning portions are, so I will use those when I file taxes.

 

 

529 Distribution to match 2023 scholarship went thru in January 2, 2024

I sent you a private message.

Hal_Al
Level 15

529 Distribution to match 2023 scholarship went thru in January 2, 2024

Q. Is 2nd option available to us, can he claim AOTC? 

A. Yes, but only as a non-refundable credit. The credit can only be used to reduce an actual tax liability.  He can only do so, if you do not claim him as a dependent (you won't get the $500 other dependent credit). He still indicates that he CAN be claimed as a dependent.

 

The math is similar, even if your numbers are different. It's a matter of allocating expenses for the best outcome. Using a different example:

$49,000 Scholarship

$45,000 529 Distribution

$63,000  Tuition and other Qualified educational expenses (QEE)

$18,000 room and board

 

Allocate $4000 QEE to the AOTC.  That leaves $59, 000 (63,000 - 4000). That's enough to fully cover the scholarship and have $10,000 left over to allocate to the 529 distribution.  $18,000 room and board + $10,000 QEE = $28,000 for the 529 distribution. That is less than the total $45K distribution. So, some of the distribution earnings will be taxable. 

 

To reduce the taxable amount, you declare $11,350 of the scholarship to be taxable.*  Now we have $18,000 + $10,000 QEE + $11,350 additional QEE = $39,350 to allocate to the 529 distribution.  39,350 / 45,000 =87.44% of the earnings are tax free. Only12.56% is taxable. 

 

 

*$11,350 + $2500 wages = $13,850 standard deduction. None of the scholarship or wages get taxed. 

 

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