Q. How can I get TurboTax (TT) to consider $10,000 of the QTP disbursement to be income, give us the education credit and not take the 10% tax penalty?
A. That should happen automatically. Enter the 1099-Q before you enter the 1098-T and other expenses.
Go back to the education expenses and scholarships section. At the screen titled "Your Education Expenses Summary". Click edit next to the student's name. That should take you to a screen “Here’s your Education Summary”. Click edit next to “Education Information”. You should reach a screen titled “Amount Used to Calculate Education Deduction or Credit”, verify the amount ($10,000) you want to use or change it. If you never get that screen, or still don't get the expected result, reply back and I'll give you a workaround.
You say $6358.48 additional QHEE for the purpose of QTP/529 and ESA/Coverdell disbursements. You didn't specifically mention room &board (R&B). While R&B are not QHEE for the tuition credit or tax free scholarship, R&B is QHEE for a 529/ESA distribution.
Making some of the student's scholarship taxable is usually a better alternative to making the 529 distribution taxable, depending on how much other income the student has and/or whether the scholarship is restricted to paying tuition.
The full $10,000 of the disbursement does not become taxable, only a portion of the earnings.
Example:
$10,000 in educational expenses(including room & board which is only qualified for the 1099-Q)
-$3000 paid by tax free scholarship***
-$4000 used to claim the American Opportunity credit
=$3000 Can be used against the 1099-Q (on the recipient’s return)
Box 1 of the 1099-Q is $5000
Box 2 is $2800
3000/5000=60% of the earnings are tax free; 40% are taxable
40% x 2800= $1120
There is $1120 of taxable income (on the recipient’s return)
