I assume that your 529 distribution was totally used for qualified expenses, so that no part of it was taxed on the federal return.
That means that none of the 529 distribution was included in your federal AGI that transferred to the state return. That means that none of the distribution was included in the income you reported on your state return. So, you don't take a 529 deduction on your state return because it was already deducted in the AGI amount transferred from federal to state.
The 529 interview, in the MI software program, is for those rare cases when the 529 distribution was taxable on the federal return but not the state.
As the state letter says, "any amounts that......are already deducted on the federal return to arrive at the AGI, do not qualify for this subtraction" (deduction). The state is most likely correct, you owe the additional amount.
