Respectfully, JillS56 is wrong here. Distributions up to the amount of a tax free scholarship are NOT subject to the 10% penalty regardless of how that money is used. (Note though that the earnings on the original deposit(s) are taxable as ordinary income.) See IRS Publication 970 where it states:
Additional Tax on Taxable Distributions
Generally, if you receive a taxable distribution, you must also pay a 10% additional tax on the amount included in income.
Exceptions. The 10% additional tax doesn't apply to the following distributions.
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3. Included in income because the designated beneficiary received: a. A tax-free scholarship or fellowship grant (see Tax-Free Scholarships and Fellowship Grants in chapter 1); b. Veterans' educational assistance (see Veterans' Benefits in chapter 1); c. Employer-provided educational assistance (see chapter 10); or d. Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance. This exception only applies to the extent the distribution isn't more than the scholarship, allowance, or payment.
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