Help with 529 and AOTC questions

Parents Forum
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Newbie here although I have been reading threads in this community throughout the end of my child’s college search and it was very helpful. I wish I had found this place sooner honestly.
Child is a freshman and I am navigating my way through how to effectively use our 529 account and also get the AOTC which I just learned about.

1st question/issue: The way her bill comes from college, it does not distinguish how her scholarships get applied. So as a general example her total semester bill is let’s say $40k in charges (tuition, fees required like resource and activity, improvement fund, housing, and dining). Then $30k in scholarships. My child took a loan so that takes off $2750. I then need to pay $7250. I had the 529 account pay that to her school. Is that going to be an issuer with taxes? How do I know if any part did not apply to a qualified expense when the bill just breaks down charges on one side and credits on the other?

Also, in regards to the 529, I paid that entire balance from her 529. They covered her first semester books. I was told by the college to pay for the books and then they would reimburse me. It was not explained how that would happen but I paid out of pocket and then was told they would refund my child on her bill. Since the bill was paid in full she had to wait for a refund check. Now I read that any refunds after 529 payments are applied can be an issue? But I can show I paid for those books out of pocket so maybe it is ok?

2nd question/issue: So similar bill comes in for spring semester. I want to pay with the 529 account again in full for what we owe but clearly do not want to make any more mistakes. And I just learned about the AOTC and read any money used from a 529 can’t be used to claim the AOTC so to get the full credit, do I need to pay $4k out of pocket and then only pay the remainder from the 529? Frustrating because this is what I saved in a 529 all these years for is to use it but I don’t want to miss a credit I could get either. And again with the bill breakdown, is there an issue with what is considered tuition to even get the credit?
Any help or advice would be greatly appreciated. I am in over my head on this stuff.
Thanks

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Ugh. First post so I can’t seem to figure out how to edit my post. I have no idea why I used the acronym EOC when it should be AOTC. If I can figure out how to fix my title and post I will. Sorry.
I meant american opportunity tax credit

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@BelknapPoint

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When the school doesn’t break down where the scholarship dollars are applied, assume that they first go towards expenses that are qualified for tax free treatment of the scholarship. This would be “tuition and fees required to enroll at or attend an eligible educational institution” and “course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in your course of instruction.” Any scholarship money that exceeds these qualified expenses is taxable income for the student. Use 529 dollars to pay for other expenses, like room and board, that are 529 qualified expenses (important: this is different than tax-free scholarship qualified expenses) that have not been paid by scholarship money.

Who is the “they” that paid for your daughter’s books? If the school paid for the books, you can’t then take money from the 529 to cover the same expense without being taxed on the earnings portion of the 529 money, plus a 10% penalty (“additional tax”).

AOTC qualified expenses can’t be paid with tax-advantaged money (tax-free scholarships, 529 funds, etc.) and also be used to claim the AOTC. This would be doing what’s known as double-dipping. The coordination between these various tax benefits can be complicated. You may have the option to declare as taxable $4,000 in what would otherwise be non-taxable scholarship money or 529 distributions to free up space to take the full AOTC. You should review IRS Pub 970, Tax Benefits for Education, as a starting point for wrapping your head around these issues. Begin with Chapter 1 (Scholarships, Fellowship Grants, Grants, and Tuition Reductions), Chapter 2 (American Opportunity Credit), and Chapter 7 (Qualified Tuition Program (QTP)), especially “Coordination With American Opportunity and Lifetime Learning Credits” on page 52.

2022 Publication 970 (irs.gov)

And don’t be reluctant to consult with a qualified and respectable tax advisor.

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I think it’ll become clear when you read pub 970, linked above.

There are specific examples for coordinating 529 and AOTC. Don’t worry, it isn’t the case that you can’t take the AOTC if you paid all eligible expenses from a 529; worst case is that you’ll pay tax (but not penalty) on the earnings portion of the 529 distribution. Pay attention to definitions of qualified expenses for AOTC vs QTP/529s; they aren’t the same.

Also keep in mind that you can only take the AOTC for 4 years. Most students are in college during 5 tax years.

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Thank you so much for your thorough response. Very helpful and I appreciate the time you took to respond.
Sorry, “they” was referring to the college. They covered her first semester books. She won a raffle. They never explained how that would work. After I paid for her semester bill it was time to purchase books and the college informed me to purchase and send them the receipt and they would reimburse. I had no idea it would be a credit back on her paid bill (which I paid from a 529 to the school directly) and then they eventually cut my daughter a check for that refund amount. In reviewing pub 970 I see that isn’t going to go well since it will show as a refund and I did not reimburse the 529 within 60 days. Yet I have receipts I paid that amount for a qualified expense. I guess I messed that up or it would have been better to not have the 529 send the money to the school and had them reimburse me so I could reconcile the book purchase and what was also paid to the school for the bill. Books were not even a consideration in paying the college semester bill. It is how they handled the reimbursement part I think that will hurt the taxes I guess. For me it was a wash…I paid for the books, they in turn paid my daughter back via bill refund. But now the tax issue due to the 529 refund. I wasn’t in any way trying to pay for the books from the 529 knowing I would be getting that money back from the college. It just so happens that is how they reimbursed. I was assuming I sent them a receipt for the books and they were cutting me a check. No 529 involved

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Thanks for your reply. I did actually read some sections of pub970 before posting here. And I can admit, I found it confusing. It did not come together for me in the way I was hoping. Granted I was reading sections very late at night and taking notes but not really reconciling it in a way I thought matched my scenario. I am going to review it again to wrap my head around it better especially after the comments above which helped me in a way I wasn’t seeing in pub 970. I have a lot to learn clearly. The 5 tax years is helpful if I clearly didn’t get it right for this first one.

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If it helps, I’d try to get the big picture in place before bringing in concerns about the books and the loan.

Others who have done this more recently can feel free to correct me here, my memory is a bit vague

So, let’s start with hypothetical numbers. You mentioned 40k total so I’ll make some numbers up based on that.

30k in tuition and fees, books, etc. that would be qualified expenses for tax-free scholarships.

Another 10k in room, board, fees, etc, that would also be qualified expenses for the 529.

30k scholarship.

~7500 529 withdrawal to school.

The way you can treat this on your taxes:

Treat the first 4k of tuition paid as available for AOTC.

Apply the 529 withdrawal next.

So now you’ve claimed the AOTC and applied 529 withdrawals to 529 eligible expenses, “using up” the first 11,500 of expenses.

Now you need to apply the scholarship amount:

18.5k (30k of qualified expenses -11.5k already allocated) of that will not be taxable.

11.5k will be the taxable portion of the scholarship. This is taxable income reported by the student.

Taxable scholarships are treated as unearned income for the purposes of the kiddie tax. However, they are treated as earned income for the purpose of calculating the standard deduction. So depending on your student’s other income, they might pay no tax at all.

Now, back to the loan. I don’t have any experience with loans but I don’t believe you are required to earmark the loan toward any of these expenses. So it’s irrelevant. (However, if you plan in the future to repay the loan using 529 funds, it needs to have been used for qualified expenses).

As for the books, I’d just include the expense in your calculation of qualified expenses. Depending how they treat the credit to the account it’s possible that it’s either a wash or can be ignored as part of these calculations.

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Very helpful. Thank you.