There are multiple ways to allocate educational expenses. The bottom line is it's tricky using TurboTax (TT) to get the results desired or even the best results. TT has assigned (almost) all the expenses to AOTC and that forces some of the 1099-Q to be taxable.
Her plan was good: only take $2000 AOTC and use the 529 plan for the rest. But the tax on $1320 should only be about $158 (assuming12% bracket). You may want to take the extra $500 AOTC, instead. The 10% penalty doesn't apply because you use those expenses to claim the AOTC.
If not, here's a simple workaround: you know that none of the 1099-Q is taxable. So, so just don't enter the 1099-Q in TT.* When you enter the 1098-T, enter only $2000 in box 1. The 1098-T is only an informational document. The numbers on it are not required to be entered onto your tax return. The 1098-T that you enter in TT is not sent to the IRS.
*On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution."
