Q. Wouldn't that be considered double-dipping because you received the $2500 tax credit, for the $4K of expenses?
A. No, because, as your surmised, that makes $4K of the 529 distribution non-qualified. In your case that doesn't matter. Yes, you have taxable income, from the non qualified distribution, added to your other income. But your income is so low that there may not be enough to get you into even the lowest tax bracket. But, even if some of it is taxable, the non refundable portion of the AOTC kicks in and covers it. It's not double dipping. You were always entitled to the $1500. But, before the extra income (from the non qualified distribution), there was no calculated tax to apply the credit to. Now there is (or may be).
Oh yes, it's confusing! That's why there's a whole tax prep industry! TurboTax (TT) can handle this complicated calculation and will prepare IRS form 5329 to calculate and claim the penalty exception.
