Level 11

The software is powerful but can be quirky in this area.  I'll respond generally but there may be things you'll need to fiddle with in data entry to get the correct outcome.

You can claim AOTC on up to 4 years of tax returns as long as the student is an undergrad at the beginning of the tax year.  Sounds like in your case you want that to be years 2-5 instead of the usual 1-4.  That's fine.

On the 529 distribution, pay attention to the 1099-Q recipient.  Sometimes this is Mom & Dad, sometimes this is Junior.  The income is taxable to the recipient.  In contrast, the education credits follow the dependent.  So presumably Mom & Dad will claim Junior and his education credit, but Junior might have to file a return if he was the recipient of the 529 money.

In terms of penalty on the 529 money, it's probably the scholarship that's preventing the penalty (not anything having to do with the credit) but you have to manually cross reference between the 1098-T worksheets and the 1099-Q worksheets to get the taxable amount correct.  So make sure your 1099-Q Wks knows that you've already used education expenses for the Lifetime Learning Credit.  Also, keep in mind there are different rules.  So the 529 money could be used for room & board or a computer and still be tax free while not taking away any qualifying expenses for your education credit.

Are we having fun yet?