Code 1 is the correct code for the payer to have used in box 1; you must enter the code provided by the payer. Entering code 2 instead will only cause problems.
The payer plays no part in determining whether you had a birth or adoption that would qualify you for this exemption. It's your responsibility to include Form 5329 with your tax return claiming this as an Other reason exception, which TurboTax does when you enter the amount in the Other reason box on the page where you enter the amounts eligible for a particular penalty exception, in this case not to exceed $5,000. What TurboTax does not do is provide you with a way to attach an explanation.
