Claiming scholarships for penalty-free Coverdell ESA distribution

[Judy2843]

Not knowing if my student would graduate in four years (or more) and what that overall financial commitment would ultimately look like, we did not take non-qualified distributions from her Coverdell ESA equal to scholarships in the years in which they were granted. I now have an overage in her account that will be distributed as non-qualified. The amount is less than the scholarships and should be taxed, as I understand it, but should be penalty free. Any guidance or suggestion as to how to handle the deferred nature of claiming the scholarships? Or is any explanation necessary? Thank you!

[dcandmc]

As far as I know, there is no direct IRS guidance on how soon the scholarship penalty exception must be used, but my personal opinion is that the exception does not expire and therefore may be used during and for any period of time after the tax year in which the scholarship is received. To document for the IRS that no "additional tax" is owed when the earnings portion of the non-qualified distribution is taxed as ordinary income, you must file with your tax return IRS form 5329 with Part II completed. No explanation as to why a penalty exception applies is required on Form 5329, but of course there is no guarantee that the IRS won't follow up with an inquiry.