Claiming a tuition credit, instaed of using the tuition to offset a 529 distribution is an exception to the 10% non qualified distribution penalty. You still have to pay tax on a portion of the distribution, but not the penalty.

Usually the credit is more generous and your are advised to use the full $4000 for the credit.

Example:
  $10,000 in educational expenses(including room & board)
   -$3000 paid by tax free scholarship
   -$4000 used to claim the American Opportunity credit
 =$3000 Can be used against the 1099-Q

Box 1 of the 1099-Q is $5000
Box 2 is $600
3000/5000=60% of the earnings are tax free
60%x600= $360
You have $240 of taxable income (600-360)

No, do not enter in the income section.  Enter at the 1099-Q screen.  
TurboTax *should* give you a screen to enter the penalty exception info.  If it appears to be charging the 10% penalty,  try typing> form 5329 >in the find box.
If you desktop software, you can enter the penalty exception directly on form 5329. With online program, you have to use the interview.