I have an update to my question about 529 Coordination with American Opportunity and Education Credits.

[portalmenow]

I claim my son as a dependent, and file his 1098-T in order to receive the American Opportunity Credit and also Education Credits. This year my son's income exceeds the tax threshold, so he will be filing also.  He is the named beneficiary of two 529s, and the amount distributed for 2017 matches school expenses (tuition, room & board, books) exactly.  I’ve read that if I file Form 8863, the expenses taken into account in figuring the American opportunity credit (Form 8863 line 27) should be subtracted from my son's total qualified education expenses (which is the exact amount distributed). This results in an Adjusted qualified education expenses (AQEE) which does not match 529 total distributions and will result in taxable income for my son.  Is this correct? If so, what forms would my son have to include with his return, or would I be better off  not claiming the American Opportunity Credit and Education Credits?  I’m going crazy trying to figure this out.

Thank you so much for your response.  As the account owner, I requested distributions so that my son is the recipient and 1099-Q Box 6 is not checked.  I want to make sure I have this – my son would not enter the 1098-T or 1099-Qs and he would follow the Less Common Income instructions. Does entering “Scholarship” trigger the appropriate worksheet? It is other taxable income, but certainly not a scholarship. Pub 970 calls it   “distributed earnings not used for adjusted qualified education expenses”.

New question - does the "other taxable income" have to be entered on the state tax form, and if so, where?  Thank you.

[KrisD · Accepted solution]

Yes, this is correct. The IRS is flexible about students, or the the taxpayer claiming the student's exemption, getting the best tax break for their situation. If the student (your son) is your dependent, you enter the forms (1099-Q and 1098-T) as well as all the other pertinent education information. Please enter the 1099-Q FIRST. Once you select "Maximize My Tax Break" the program will figure the best credit for your situation. 

Room and board can NOT be used for an education credit, but can offset the tax on the distribution reported on the 1099-Q.

You seem to have this figured out. If you are eligible and feel the best credit is the American Opportunity Tax Credit, allocate up to $4,000 tuition, fees, books and supplies towards the credit (Lifetime Learning up to $10,000). Add the Room and Board to whatever tuition, fees, books and supplies expenses are left and use this amount against the distribution. WHATEVER AMOUNT IS LEFT WILL BE TAXABLE TO THE RECIPIENT. The distributions should always be made by the student (or transferred directly to the school) so that the tax will be at the student's rate. 

To see what the program is allocating to the credit, go to the last screen in the "Education Information" interview under the education section. (see screenshots). You can change the amount you want to go to the credit here.  The program will generate a worksheet to show how much of the distribution to report as taxable income. 

Click the link below for IRS Pub 970 with more information:

CLICK HERE for IRS Pub 970 Education Credits

If your son does need to report income he should follow these directions: 

To report Scholarship income as taxable income

Sign into your account and start your return

Click Federal on the left side-bar

Click Wages & Income on the top

Scroll down to Less Common Income and click Show more

Scroll down to Miscellaneous Income, 1099-A, 1099-C and click Start

Scroll down to Other reportable income and click Start

“Any Other Taxable Income?” screen click Yes

“Other Taxable Income” screen type a description such as   Taxable 529 Distribution   into the Description box

Enter the amount into the Amount box and click Continue

[Edited 03.17.18 | 4"00PM]

[portalmenow]

Thank you so much.  As the account owner, I requested distributions so that my son is the recipient and 1099-Q Box 6 is not checked. I want to make sure I have this right  – my son would not enter the 1098-T or 1099-Qs and he would follow your Less Common Income instructions. Does entering “Scholarship” trigger the appropriate worksheet? It is other taxable income, but certainly not a scholarship.  
Pub 970 calls it   “distributed earnings not used for adjusted qualified education expenses”.

[KrisD]

Yes, using a description referring to the 529 is more appropriate than scholarship. (I updated the original answer). Your exact phrase may not fit, but something similar is fine. According to Pub 970 page 52 "Report it on Form 1040 or Form 1040NR, line 21".
Your son does NOT enter the forms 1099-Q or 1098-T. Use the worksheet from your taxes to find the amount he needs to report (it is based on a percent of earnings over basis). keep a copy of the 1099-Q, 1098-T and worksheet with both your files. There is no worksheet for your son's return, it is simply reported on line 21 with a description to satisfy the filing requirements of the IRS.