Thank you frustrated.  Here is my client's information.  It sounds like your second scenario but it is not figuring a 10% penalty. 1099-Q is Gross Distribution=$4621, Earnings=$1691 and Basis=$2931.

My client's dependent had $5215 qualified education expenses, so I used $4000 of that for him to qualify for the $2500 AOC.  Bill from Iowa that posted in 2019 about this said to use all the tuition first because that would be a bigger refund, which it does.

On Form 5329, it reports $1691 as taxable distribution and zero penalty on lines 7 & 8.  If he is subject to a penalty, why is it doing zero.  I would have to override it to change it and it won't be able to be efiled.