Q. I have read that I can withdraw up to the scholarship amount per calendar year without having to pay the 10% penalty - is that so?
A. Yes. The earnings portion of the distribution (withdrawal amount) will still be taxable, but there will be no penalty.
Q. Assuming it is, how will this be reflected on the tax forms?
A. The taxable portion of the 529 distribution (the earnings) will be reported on line 8 of Schedule 1 with the notation Taxable portion of 1099-Q (or similar wording). There is a line on form 5329 to claim the penalty exception. TurboTax (TT) can handle this, but it can get a little tricky. It's helpful if you know what the expected outcome is (so, you've asked good questions).
Q. I assume my financial institution (529 plan administrator) will see the withdrawal and send me a tax form?
A. Yes, form 1099-Q.
Q. How will the plan administrator know that the penalty is not applicable?
A. They won't and they don't care. They only report what's required on form 1099-Q (total distribution, broken down between earning and basis). It's your job to tell the IRS you have a penalty exception.
Q. Can I still show her as a dependent given she has no income in 2021?
A. Yes. Scholarships are ignored in the dependent support test. That is, she is not considered to be supporting her self (it's essentially third party support). So, she can continue to be treated as a qualifying child dependent through age 23, if a full time student. Even though she will be reporting scholarship as income (and maybe some 529 earnings), those are not considered self support, for purposes of the qualifying child dependent support test
@Critter-3 said "As for the 529 plan withdrawals; they should be done in her name"
That is generally true, but it can get complicated. The only way to be sure is prepare trial returns both ways and compare. You may actually want to distribute some of the money to the student and some to the parent. The earnings portion of a 529 distribution is unearned income and subject to the "kiddie tax". As such, a "child" under 24 (whether a dependent or not) will not be allowed a full $12, 550 (2021) standard deduction. But, the room and board portion of the scholarship will also be taxable income to the student. Taxable scholarship is treated as earned income for purposes of calculating a student's standard deduction, so she will be allowed the standard deduction to cover (up to $12,550) of the taxable scholarship.
@Critter-3 said "For instance if she takes out $12K then the same amount of the scholarship will be taxable on her return"
The amount of scholarship that is taxable is not related to the 529 distribution amount *. Only the amount of the scholarship used for qualified expenses (tuition, fees and required course materials) is tax free. The rest (mostly the room and board part) is taxable.
* The amount of distribution that is penalty free is related to the scholarship amount).
