Under scholarships/grants, I entered the total scholarship amounts that matched up with the distribution under "other scholarships". After clicking through, it only said that the amount counts as income. Which I understand. However, the 5329 worksheet is still treating the withdrawal as subject to the 10% penalty. This is being fed from the 1099-Q. I don't know how to override it or indicate this isn't subject to penalty.
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In order for the taxable 529 distribution to not be subject to the 10% penalty, the scholarship must remain nontaxable.
In some cases, a student can choose to pay tax on a scholarship in order to receive a benefit from an education tax credit. In this situation, the scholarship is taxable and the 529 plan may be taxable too. If some of the 529 plan distribution is taxed because any valid tuition expense is applied to the credit, the 10% penalty will not fit the "nontaxable scholarship" exception.
Turbo Tax does reconcile all these variables, so ensure that something like this isn't happening with you.
I tested a situation with a completely nontaxable scholarship and no education tax credit. The earnings on the 529 were taxed, but not subject to the 10% penalty (*per the code, as you stated). If you are seeing a penalty, you may have taxable scholarship income and/or a mistaken entry in fields above.
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