I think the OP is saying that they have saved money in a 529 over the years and now find themself in a position of not having to use it for this child. They want to use the 529 money they had saved for this child and allocated to this child to pay for whatever they can so that their child begins to receive more of their net pay sooner. I would be in the same situation if my DD gets in next year and I was thinking along the same lines. I was thinking of it in terms of a reward for that child. They worked hard, got into a great school that financially does not put any burden on the parents and as a reward, use the 529 money to pay for the expenses so that they will be rewarded with more money in DD's bank account.
With respect to 529 plans, and SA's, I think I have a pretty good understanding of how these work. Firstly, you can change the beneficiary to a Sibling, or just leave the dollars there for grad school.
It is correct that SA attendees are exempt from the 10% penalty if it is just paid directly to them as individuals. The 'gain' in the 529 is subject to Capital gains tax, but Cadets/Mids have taxable income of $6 an hour, so they qualify as working poor. They can 'earn' up to $36k a year in investment and earned income, and because they are independent (because of the non taxable income value' of the scholarship) they are in a zero percent tax bracket for Capital gains. So basically, if you are not going to reallocate it to a sibling, its a good idea to feed it out (especially Plebe year when they only make $6k on their W2) while in school.
SA's are NOT "Eligible Financial Institutions" to receive 529 payments because they dont participate in federal financial aid programs. That said, its such a small number of people that are affected by all this detail, it would not be surprising if you asked your 529 fiduciary to send a check to the treasurer to pay off the Plebe loans, that they would do so. The SA will cash it and credit it against the loan, because they have no dog in that fight. That wont affect their take home pay initially, but gets trued up when they are upper classman.
The main takeaway, is the 10% penalty is waived, and if spread out carefully, the capital gain will be taxed at a zero percent rate anyway, and can help build a nice pot for them to start their commissioned life on....And the SA will cash the check if your 529 steward will write it to pay off the Plebe loans.
What you need to be aware of is that SA's are not eligible educational institutions. On the other hand, if you answer every single turbo tax question correctly, pay off your Plebe loan with 529 money, and dribble out 529 payments directly to your kid, you can move quite a bit of tax fovored savings into their get started in life pot tax free.
