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Rule #1 for education expenses: Assume the 1098-T is wrong.
Get a financial transcript from the school. The rules are very flexible and taxpayer friendly.
Step 1: Scholarships - they come out first. If, however, the terms of the scholarship permit the funds to be spend on non-tuition (i.e. room & board, computer, etc.) you may benefit by allocating a portion of the scholarship to these expenses. This makes it taxable income to the student so I wouldn't do this unless it gets you AOTC.
Step 2: Use tuition to maximize AOTC. I generally recommend to clients that bother to ask that they pay $4K out-of-pocket (outside of the 529 plan) if they're income is low enough to qualify for AOTC. Makes things much easier. We don't have to do funky allocations, we don't have to make part of something taxable to get the most benefit. We don't have to pay a tax professional to spend 2 hours optimizing expenses for the best "family" tax result.
Step 3: Take what's left for tuition (after subtracting scholarships and $4K AOTC allocation) and add it to other 529 plan qualified expenses which include room & board, books, computers, Internet access, etc. Use the total to offset 529 plan distributions.
Step 4: Anything left that came out of the 529 plan will be income to the recipient but mostly not taxable as a return of contribution basis.
Step 5: If you did have any 529 money survive to step 4, you get penalty relief for scholarships and amounts used for education credits. So maybe some tax, but probably not any penalty, so make sure you review Form 5329 to remove any penalties you can get out of.
Step 6: If things are this messed up, you may need to read, cite and "rely" on a Notice of Proposed Rulemaking from 1/18/2008. There are no provisions in the code or regs that address timing of the 529 distribution in relation to the qualified expenses. Most folks go with "same tax year" which is the approach I would recommend, and that generally keeps you out of trouble. The link above I only use "in case of emergency" and do so with full disclosure on the appropriate tax return(s). Crossing your fingers can't hurt.
Are we having fun yet?
Rick