529 Distribution and Scholarship

Q. My understanding is that there is no reason to list the 1099-Q on her return or mine and no tax is due?

A. That is true. If the 1099-Q is covered by qualified expenses, you do not need to file the 1099-Q. However, you cannot double dip.  You cannot use expenses, for the 1099-Q,  that were covered by tax free scholarship or that were used to claim a tuition credit.

Q. My understanding is that the form 1098-T is to be used to complete Form 8863 to claim education credits.

A. Yes, normally.  But dependents are not generally eligible for tuition credits*.  Your AGI is above the threshold for being eligible to receive this credit. 

Q. Box 5 of her 1098-T exceeds box 1.  Is the difference taxable?

A. Yes

Q. If so,  what are considered qualified expenses above the tuition and fees the college received directly?

A. Books and other required "course materials". Generally, that includes a computer.

Q. Is it  filed on her return or  mine?

A. Taxable scholarship is reported on the student's return.  If that is her only income and is less than $12,400, she does not need to file. 

Since scholarships have paid so much of her expenses, some of the 1099-Q may end up being taxable,  See below for details. Note, it may actually be better to pay tax on the scholarship than the 1099-Q. This is allowed if the scholarship is not restricted (must be used for tuition).

* If she has enough income to have a tax liability, she can claim a non-refundable credit, but then you have to forego her $500 dependent credit. 

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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 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 (usually on the student’s return)

Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360)

**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. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip!  When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit.