529 withdrawal to match scholarship, tax but no penalty

Question

Hi,

My daughter, a college sophomore, receives an annual scholarship that offsets almost 1/3 of tuition.  This year, 2025, we want to make a non-qualified withdrawal in that amount.

The earnings portion of this withdrawal is taxable, but should not be penalized an extra 10% because it is matched by a scholarship.

However, I'm seeing a discussion from tax year 2024 implying that FreeTaxUSA does not support this legitimate scenario.  The person who posted was unable to get the software to bypass the 10% penalty:

https://www.bogleheads.org/forum/viewtopic.php?t=453539

Can anyone corroborate that I'll have the same problem filing 2025 taxes, and/or offer a workaround?  Thank you.

L5Player · Answer

Thank you very much for checking this out!  Sounds like the person who posted on Bogleheads either didn't follow the questions correctly, or there has been an enhancement to the software since last year.

In any case, I appreciate your time.  Cheers

MatthewD · Answer

Hi L5Player, We are constantly making improvements to our software. I tested the 1099-Q (529 distribution) to check if we do or don't support this situation. There is a question in that section asking, "Did (your dependent) receive tax-free educational assistance?" By answering YES to the question you are not penalized on non-qualifying distributions. You are only taxed on the earnings. The FAQ for the question says the following: "What if I took a 529 distribution and had tax-free educational assistance? Normally, if you take a 529 distribution and you don't use those funds for education-related expenses, you'll be taxed on your earnings from the distribution and you'll be charged an additional 10% penalty. However, if your 529 distribution was less than any tax-free educational assistance received by the 529 beneficiary, you may qualify for an exception for the 529 distribution 10% penalty (note, the earnings may still be taxable). You'll need to enter the beneficiary's education-related expenses and tax-free educational assistance so FreeTaxUSA can calculate your taxable earnings and any 10% penalty that may apply." I hope that helps. We do support this particular situation.