If a non-qualified distribution is made from a 529 plan, it is generally taxable to the extent of earnings and a 10% penalty is added. But if a scholarship is received, a distribution can be made without the 10% penalty, For example, if for a student's freshman year, there is a $25,000 withdrawal is made in a year when a $10,000 scholarship was received and applied to a total of $30,000 of qualified education expenses (assume no AOC or tuition deductions), the withdrawal would have exceeded by $5000 the $20,000 of net remaining eligible expenses after scholarship, The $5000 would be taxable as to the 529 plan earnings included in the withdrawal, but there would be no 10% penalty. But what if the parents, rather than withdrawing $25,000 that year, only withdrew $20,000, because they wanted to avoid depleting the 529 account before they know that all college costs had been covered? Four years later, there is left in the 529 plan $5000. The parents withdraw it and want to avoid the 10% penalty on the taxable earnings by pointing to the freshman year scholarship and the "unused" protection against the 10% penalty from freshman year. Is that permissible? We're not talking about making sure that eligible expenses are counted in the proper tax year--all expenses were properly allocated. We are talking about parents not wanting to "waste" 529 money by withdrawing it too early rather than taking advantage of penalty-free withdrawals based on scholarships AFTER there are no college costs left to be paid. I can find no guidance on this, despite the wisdom of a tax policy that encourages parents not to withdraw 529 plan money until they are sure that it won't be needed just because a scholarship is received in a particular year. I can find no guidance on this. TurboTax does not make it easy to try to use a prior year scholarship to eliminate the 10% penalty in a post-graduation year that has no current eligible education expenses. Anyone confident of an answer either way?
