You owe tax on the entire earnings, but no penalty. You owe the tax because he had no expenses that were not covered by tax free benefits, unless his housing, food* and books (including a computer) was more than the $10,680 he received. There is no penalty because receiving tax free benefits, for expenses that woulda been paid by the 529 plan, is a penalty exception.
*Room and board (R&B) (housing & food) are qualified expenses for a 529 distribution but the amount you can claim is limited to the lesser of your actual cost or the school's R&B “allowance for cost of attendance”.
Q. How to enter in TurboTax (TT)?
A. Enter the 1099-Q. When asked who the student is answer: someone else not listed here, even if he is still your dependent (lying to TurboTax to get it to do what you want does not constitute lying to the IRS). Enter the student's name when asked. A few screens later, you'll get one simple screen to enter expenses. Press Done at the 1099-Q summary screen, to get there. Also enter the amount of the GI benefits in the box "Tax-free assistance" (actually you only need to enter $5000 in the room & board box and $5000 in the tax free assistance box) This reports the earnings as taxable and claims the scholarship exception. You do not have to deal with the complicated “Educational expenses and Scholarships” (1098-T) section later. TT will prepare form 5329 to claim the penalty exception.
