Good question.

Yes, the code 2 automatically means that the withholding is subject to penalty. Had the conversion been made after age 59.5, the code would have been 7 and no penalty would apply to the withholding.

The rationale must be that there is no need to issue a separate 1099R for the withholding because it is obvious where it went and the Box 7 code will also indicate whether the taxpayer was 59.5 or not. If two conversions were done in the same year, one before 59.5 and one after, then there would have to be two 1099R forms coded 2 and 7. The withholding on the 2 code would be penalized and the withholding with the 7 code would not. And the funds cannot be used for another purpose subject to penalty waiver if they in fact went to the IRS.

I guess the IRS decided not to explain this in the 1099R Inst., but they could have footnoted it along with the Box 4 Inst. An explanation might be located somewhere else in the 1099R Inst, perhaps in the 1099R Gen Inst., but I only looked in the 1099R Inst.

The client could have made up withheld amount within 60 days of the distribution, and that would have completed the conversion and eliminated the penalty.

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• The client would have to complete the conversion within 60 days of the initial distribution by using other money to add to the Roth IRA. The full amount of the distribution is then reported as a conversion on Form 8606, and the IRS accepts that because the 8606 reports the full Box 1 amount of the 1099R.
• If the client did the conversion by 60 day rollover and not direct transfer, the 1099R would have a code 1 if under 59.5. Again, even with the code 1, the 8606 will override any penalty and Form 5329 should not be needed.
• One situation that would require a 5329 would be when the client DOES NOT replace the withheld amount and only converts the amount other than the withholding. Notwithstanding my comment in the 2010 post, tracing rules should not apply to IRA distributions. For example, if a client had a higher education expense equal to the withholding, he could file a 5329 and enter the higher education exception code to waive the penalty on the withheld amount. In other words, having a penalty exception anytime in the year allows that exception to be used to waive the penalty that otherwise would have applied to the withheld amount, so the 5329 would address the withheld amount and the 8606 would cover the converted amount.
• Despite absolutely no IRS instructions on withholding related penalty reporting, apparently this is not causing any problems with IRS inquiries despite taxpayers reporting in different ways.

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It’s generally improper to report the withholding on the same a code 2 Form 1099-R that reports the Roth conversion.  Unless the payer knows that some other exception applies, the amount withheld for taxes is not an amount known by the payer to have been converted to Roth and should be reported on a separate code 1 Form 1099-R.

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