You found the problem but you also found the solution. The problem is: it's complicated. The solution is just don't report the 1099-Q .
Q. 1. If all withdrawals were made for qualified educational expenses as listed above, should any taxes be owed for withdrawals?
A. 1. No.
Q. 2.Do I have to report her 1099Q at all?
A. No. If your student-beneficiary has sufficient educational expenses, including room & board (even if she lives at home) to cover the distribution. When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. It will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.
That said, you may want to pay a little tax on the 529 distribution in order to claim a more generous tuition credit.
Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q.
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)
