You will have to pay the 10% penalty on some of the distribution. Apparently, you added the scholarship on top of the expenses, in calculating how much to withdraw.
Your expenses are $29,105 + 14,000 + 300 =$43,405. That's the most you could withdraw penalty free.
You need $4000 of tuition to claim the credit. That leaves $39,405 of expenses for the scholarship and 1099-Q.
I assume the student’s $2500 of income is earned income from wages. We can make $11,350 (13850 – 2500 = 11350) of his scholarship taxable and he will still owe no tax.* He does not even need to file.
So, that means $17,925 (29,275 – 11,350 = 17925) of the expenses will be allocated to the scholarship. This is also the amount (not the full 29,275) that will be used in calculating the penalty exception
That leaves $21,480 (39,405 – 17,925 = 21,480) for the 529 distribution (1099-Q). 21480/66294 = 32.4% of the distribution is qualified; 67.6% is non-qualified. 0.676 x $40,685 (529 earnings) = $27,503 taxable income. It goes on line 8z of Schedule 1 as “Qual state (or private) tuition prgm from 1099-Q”
* Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement and the dependent standard deduction calculation (earned income + $400). It is not earned income for the kiddie tax and other purposes (e.g. EIC). For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.
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HOW TO ENTER ALL THAT IN TURBOTAX (TT)
If the student will be filing a tax return, the simple thing to do is enter the 1098-T with $11,350 in box 5 and $0 in box 1.
On your return, It’s best to use a workaround.
Enter the 1098-T, at Educational expenses and scholarships with $4000 in box 1 and 0 in box 5. Enter no other numbers in that section. That gets you the American Opportunity (tuition) credit.
Enter the 1099-Q, in ESA and 529 qualified tuition programs (1099-Q) section. When asked who the student is answer: someone else not listed here (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.
Enter $25,105 for tuition (21480 -14000 -300 +17925) for tuition. Enter $14,000 for room & board and $300 for books. Also enter the amount ($17,925) of the scholarship in the box "Tax-free assistance". 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 calculate the penalty (about $1650).
