In 2014, my daughter had:
Scholarships: 14,000 (2,500 scholarship, 5,500 Pell, 6,000 school grants) Work Study: 500 Tuition/fees/books: 8,000 Room and board: 11,000 529 distributions in her name: 11,000
She is my dependent. The scholarships are NOT restricted to tuition. All scholarships were directed applied to her college bill with any surplus refunded. The 529 distribution was paid directly to her.
Based on my understanding, 6,000 of her scholarships(14,000-8000)is taxable income. I want her to claim an additional 2,000 the scholarship as income (see Pub 970 below). This allows me to list 2000 of tuition/fees/books as QEE expenses to qualify for the AOC. In this case, her income would be 8,500 (6,000+2,000+500).
What I am not clear on is what my Adjusted QEE for the 529 plan is. From Pub 970 (see below) it appears to be:
AQEE=QEE- tax-free educational assistance-QEE applied towards AOC
AQEE: 19,000 QEE (Tuition/fees/room/board)-6,000 (14,000 total scholarships- 8000 amount that was taxed) - 2,000 (QEE use for AOC) ,000
Based on this the 529 distribution is tax free.
Q: Is this analysis of tax-free educational assistance correct?
From 2013 IRS Pub 970:
You may be able to increase the combined value of an education credit and certain educational assistance if the student includes some or all of the educational assistance in income in the year it is received. For examples, see Coordination with Pell grants and other scholarships, later.
Coordination with Pell grants and other scholar-ships.
In some cases, you may be able to reduce your tax liability by including scholarships in income. If you are claiming an education credit for a claimed dependent who received a scholarship, you may be able to reduce your tax liability if the student includes the scholarship in income. The scholarship must be one that may (by its terms) be applied to expenses (such as room and board) other than qualified education expenses.
Coordination With American Opportunity and Lifetime Learning Credits
An American opportunity or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit.