In order for the taxable 529 distribution to not be subject to the 10% penalty, the scholarship must remain nontaxable.

In some cases, a student can choose to pay tax on a scholarship in order to receive a benefit from an education tax credit. In this situation, the scholarship is taxable and the 529 plan may be taxable too. If some of the 529 plan distribution is taxed because any valid tuition expense is applied to the credit, the 10% penalty will not fit the "nontaxable scholarship" exception.

Turbo Tax does reconcile all these variables, so ensure that something like this isn't happening with you.

• Edit the Education Expenses section under Deductions and Credits
• Edit the Scholarship section and review your entry for "Did Xs Aid Include Amounts Not Awarded for 2016 Expenses?" If you put an amount there, you may be moving the scholarship to a different tax year
• Continue to the screen "Amount Used to Calculate Education Deduction or Credit". If you have an amount there, you are applying some of the 529 distribution to a credit that you may not even have. Please review this box carefully.

I tested a situation with a completely nontaxable scholarship and no education tax credit. The earnings on the 529 were taxed, but not subject to the 10% penalty (*per the code, as you stated). If you are seeing a penalty, you may have taxable scholarship income and/or a mistaken entry in fields above.