A distribution code 2 is not tax exempt but rather penalty exempt. There is a difference. Because you recharacterized your Traditional IRA to a Roth IRA, the recharacterization became a taxable distribution for tax purposes. The code 2 in box 7 acknowledges that the recharacterization is taxable, since it was originally deducted from your income but is now included into it for taxation. Since it is a distribution, and you are not yet 59 1/2 years of age, it is an early distribution. Normally, early distributions are taxed an additional 10% as a penalty. However, since you are recharacterizing the IRA, this is considered a qualifying reason to have the penalty waived. Code 2 shows that while it is a taxable distribution, it is not also a penalized distribution.
Remember: A Roth IRA is not deducted from your income when you contribute. On the other end, it is not taxed when it is distributed to you, either.
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