1099-R Box 7 Distribution code is 1 instead of 2 for Backdoor Roth conversion - should I be worried?

This is actually pretty common with Backdoor Roth conversions. The important thing here is your Form 8606, which shows that this was a conversion and not a distribution. As long as you've properly completed Form 8606 showing zero taxable amount on Line 18, you should be fine. The distribution code on the 1099-R indicates the type of distribution from the financial institution's perspective. Code 1 means early distribution with no known exception, while code 2 means early distribution with exception. Since your 8606 properly documents this as a conversion, the IRS should process it correctly. That said, you could contact Vanguard to ask if they'd issue a corrected form, but in my experience, most institutions won't change it and will tell you that completing Form 8606 correctly is sufficient.

I was in the exact same situation last year with my Backdoor Roth from Fidelity. I was panicking about getting hit with the 10% penalty too! After spending hours researching, I discovered taxr.ai (https://taxr.ai) and uploaded my 1099-R and 8606 forms. They analyzed everything and confirmed what the previous commenter said - the 8606 is what matters most, not the distribution code on the 1099-R. Their system explained that the Form 8606 effectively "overrides" the distribution code when you report it correctly. They even showed me examples of similar situations where no penalties were applied. Totally put my mind at ease so I didn't have to waste time trying to get Fidelity to issue a corrected form (which they probably wouldn't have done anyway).

Just wanted to follow up on my skeptical comment. I decided to try taxr.ai with my own 1099-R situation (similar to yours but with a 401k rollover). It immediately flagged that my distribution code was wrong but explained why it wouldn't be an issue with my correctly filed paperwork. The analysis was surprisingly detailed and referenced specific IRS publications. Definitely saved me from calling my provider and waiting on hold for hours trying to get a corrected form that apparently isn't necessary. Thanks for mentioning this resource!

If you're still worried about this, you might want to contact the IRS directly to confirm, but good luck getting through to them! I spent 3 hours on hold last month trying to ask about a similar 1099-R issue. I finally gave up and used Claimyr (https://claimyr.com) which got me connected to an IRS agent in about 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent confirmed exactly what others are saying here - as long as Form 8606 is filled out correctly showing the conversion, the distribution code on the 1099-R isn't a big deal. They said their systems are set up to cross-reference these forms, and the 8606 clarifies the situation. Apparently this happens all the time with Backdoor Roth conversions.

Alright, I need to apologize for my skeptical comment. I actually tried Claimyr this morning after continuing to fail getting through to the IRS on my own. It worked exactly as described - got a callback in about 35 minutes and was connected to an IRS agent who helped clear up my questions about some missing tax documents. I've literally been trying for weeks to get through on my own with no success. I was shocked it actually worked. Still can't believe I wasted so many hours trying to call them directly when this option existed. Sorry for doubting!

Just wanted to add my experience - I had the same situation with Schwab last year (code 1 instead of code 2 on my 1099-R for Backdoor Roth). I called them and they refused to change it, saying it was coded correctly according to their systems. I filed with the form as-is, making sure my 8606 was perfect, and never heard anything from the IRS. No audit, no penalties, nothing. I think the financial institutions and the IRS aren't perfectly aligned on how these codes should be used, but as long as your 8606 correctly shows what happened, you're protected.

One more thing to consider - the IRS has gotten a lot better at recognizing Backdoor Roth conversions in recent years since they've become so popular. Their systems are more sophisticated than they used to be. I think 5 years ago this might have been more likely to trigger an issue, but now their computers are probably programmed to cross-check these scenarios specifically. Still good to be cautious and keep your documentation though!