Background: my son has had a SMART Scholarship from Scholarship America funded by the DOD for the last 2 academic years--they paid all tuition/fees and a monthly stipend for living expenses. In exchange for this he was required to work for the DOD for 2 years after graduation. Well...he has changed his mind, he has quit the program, and soon we will need to pay back the entire amount they paid over the 2 years, or approximately $120,000.
I have $35k in a 529 ($5000 is earnings) and my parents have $15k (about $7500 is earnings) in a 529 for him. I spoke with the Bursar's office at his school and they mistakenly told me they could return all the money to Scholarship America and we could send our 529 funds directly to the school. My parents and I quickly sent all these funds, $50k, to the school and they should be there later today or tomorrow. The woman in the Bursar's office later informed me she spoke with her supervisor and learned they can only return money from this academic year as the books for last year are closed. She expects Box 6 on the 1098T we receive in 2022 will show $33,668 ($16,834 for fall 2020 and same for spring 2021) and Box 1 will show $0 (I believe she said b/c the bill came out in 2020, paid by the scholarship in 2021, so doesn't show up).
My question: what should we do?
I read somewhere to just ignore the 1099Q as the IRS doesn't even want to know about these, as long as the money was spent appropriately, and just send the money to Scholarship America. But I'm an anxious guy and want to do things by the book. I've been told one option is to consider the scholarship a loan, and take the $10,000 max on that, but it wasn't an official loan, so no 1098E, so not sure how to do that. Another option I've read about is calling it a non-qualified withdrawal to pay off the scholarship, as this avoids the 10% penalties, but we will have to lose some of the money to pay income tax on the earnings--this doesn't seem fair when the money really was for qualified expenses.
Thanks for reading such a long topic!