"You should have liquidated the account in the final year of school or transferred the left over to another qualified family member. "
Thanks for your answer. Two questions, please.
First, are you suggesting that if the scholarship was received freshman year, so long as the non-qualified withdrawal covered by the scholarship is made by the final year of school, it would not be subject to penalty?
Second, is there a written IRS instruction specifically addressing your conclusion as to deferred use of scholarships to avoid withdrawal penalties? I know that eligible expenses need to be matched to 529 withdrawals annually, but that doesn't specifically cover matching scholarships to unqualified withdrawals. For example, if 2018 scholarships are $10,000, AOC is $2,000, and eligible education expenses are $30,000, the maximum 529 plan reimbursement would be (30-10-2=) $18,000. I believe you agree that $10,000 (equal to the full scholarship) could be withdrawn in 2018 without penalty. But what if if in that scenario rather than reimbursing $18,000 from the 529 plan, only $10,000 of 529 plan assets were used for eligible expenses with $8,000 of eligible expenses covered from non-529 parental savings and only $2,000 were withdrawn from the 529 plan as a non-qualified withdrawal? In effect, only $2,000 of the scholarship would have been used to avoid withdrawal penalty, and $8,000 of 529 plan assets that might have been used rather than other parental savings was (prudently) left in the plan. If in 2023 after college graduation that $8,000 that could have been withdrawn without penalty in 2018 is withdrawn the correctness of eligible expense/529 reimbursement calculations in 2018 continue to satisfy all rules related to "matching" reimbursement of eligible 2018 expenses. For 2023, the "matching" rules are irrelevant, because there are no eligible expenses being reimbursed. A non-qualified withdrawal of $8,000 at that time, however, is equal to scholarship value that, due to non-use of 529 assets rather than other parental savings in 2018, created a "surplus" of 529 funds equal $8,000 that might have been withdrawn in 2018 but is not expressly under IRS rules no longer the basis for an unpenalized non-qualified withdrawal in later years. I'm aware of nothing in the annual expense matching guidance that says that if the 2018 eligible expense matching was correct as to 2018 expense, there is any relevance of a second application of expense matching rules in 2023 when no 529 funds are being used to reimburse expenses because no expenses exist. The "surplus" of $8,000 of unused 529 plan funds that might have been used rather than other parental savings in 2018 and that are less than the 2018 scholarship but not previously taken as an unqualified withdrawal in 2018 would not (in any IRS guidance I've seen) lose that non-penalizable status. The policy reason supporting this view is that once that "surplus" is created, college savings is promoted and education better supported if the owner of the 529 account is not forced to withdraw the funds in 2018 in order to avoid penalties. Otherwise, 529 funds might end up depleted early and fail to support graduation.
