The Form 1099-R provided by the payer is actually incorrect. You should have received a code-2 Form 1099-R for the portion that was actually converted to Roth and a separate code-1 Form 1099-R for the portion withheld for taxes. The portion withheld for taxes does not escape the 10% early-distribution penalty unless you substitute other funds to indirectly complete either rollover to a traditional IRA or a conversion to a Roth IRA. Assuming that no such substitution was done, by the payer incorrectly using code 2 to report the portion withheld for taxes, your tax return will fail to appropriately include the 10% penalty on the $7,000.
$12,000 would be about the right taxable amount for someone in the 22% tax bracket. As VolvoGirl said, The $7,000 withheld for taxes would be credited on line 25b of your Form 1040, so that $7,000 is insufficient to cover all of the increase in your tax liability resulting from the gross amount of this distribution. By falsely indicating that all of the distribution was rolled over, all $55,000 is inappropriately removed from your taxable income.
