I recharacterized to roth IRA. 1099-R has dist code 2 in box 7. upon importing the form, TurboxTax says this sum is tax exempt. But this sum gets included as income. Why?

[DanielV01]

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.

[dmertz]

Code 2 reports a Roth conversion, not a recharacterization.

On its summary page, TurboTax shows both taxable and nontaxable distributions as indication of what Forms 1099-R you've entered in total.

[marcisikoff]

It depends on the source of the IRA funds you recharacterized.

If you make IRA contributions and got a tax benefit (either on taxes as an IRA deduction or in pay as a 401(k) deduction later put into the IRA), you are in fact taking a distribution and the income is taxable but the penalty for early (e.g., under 59 1/2) is waived as you put them into a Roth.

If, however you just put money from a bank account into the IRA and moved it to the ROTH IRA, it should not be taxable since you funded with already taxed income.

[dmertz]

marcisikoff , I don't see how your reply addresses anything related to this ancient thread because the original question asked nothing about the tax consequences of the transactions.  A recharacterization to a Roth IRA can only come from a contribution that had been made to traditional IRA.  The original poster made a regular Roth IRA contribution, recharacterized it to be a traditional IRA contribution instead, then did a Roth conversion.  It's the Roth conversion that was reported on a code-2 Form 1099-R.  The original poster was also unaware that any distribution from an IRA is deemed by the tax code to be "income" whether taxable or not, meaning that the distribution is reportable on the tax return.

Finally, the last sentence you posted is not accurate.  Even if the traditional IRA contribution is nondeductible, a Roth conversion may be taxable to some extent depending on whether the individual has other money in traditional IRAs.  The taxable amount of the Roth conversion is determined on Form 8606.