Thanks for responding again. I don't disagree that the amount ordinarily taxable for 2023 would be the $8000 withdrawal portion that was earnings and not principal, plus a 10% penalty. However, there is no language in Pub. 970 that says that when scholarship money has been received (and used for eligible expenses that as a result did not consume 529 plan funds that otherwise might have been used), the avoidance of the 10% penalty can only occur for a withdrawal in the year that the eligible expenses were incurred. Can you please direct me to the paragraph in 970 that you believe addresses the scholarship issue and speaks to the waiver of the 10% penalty only in the year the scholarship was received?
The silence of Pub 970 (failure to state that a scholarship used instead of 529 funds cannot be used to avoid penalty on otherwise unqualified withdrawals in future years) makes good tax policy sense. It is not a tax-free withdrawal of the earnings portion of the withdrawal. If the policy goal is to support higher education funding by encouraging 529 funds to remain in a 529 until all education expenses have been incurred, this is supported by not forcing parents to choose between withdrawing scholarship amounts from a 529 early in college (at a time when future financial aid and future 529 investment performance may be uncertain), but recognizing that a prudent parent that does not withdraw to offset scholarships each year but then does so at the end of college has used the 529 funds prudently and not abusively.
The IRS has been in a position for years to give guidance against the silence of Pub 970 on later year withdrawals against prior scholarships and to my knowledge has not. Nor can I find anything in the accounting literature that says that scholarships cannot be the basis for later year unpenalized 529 withdrawals so long as the scholarship was applied to eligible expenses.
If the scholarship is used to avoid the 10% penalty in a year after it was received, the taxpayer should be prepared to support that use with documentation supporting the correct application of the scholarship to eligible expenses (and of the 529 plan) in the year the scholarship was received.
