Roth IRA early distribution?

I have a Roth IRA and in 2006 contributed $4K in it. Then I realized that my family's income would be above the $165K limit and I asked them to return the money. I then funded my traditional IRA to the tune of $4K. My question is, what do I do with the 1099-R that I received for the $4018.98 distribution from the Roth IRA. I don't want to be in a position where I have to pay a 10% penalty for the early withdrawal. How do I report this on the tax returns, if at all? Please advise.

You will not pay a penalty on the returned contribution, but you do have to report it.

The $4K that was returned to you before the due date of the return is treated as if it was never contributed. Include the $4,019 distribution on Line 15a of Form 1040.

The $18.98 is taxable to you in the year you received the money. Since you received the money in 2006, it is included on Line 15b and you will have to pay a $2 penalty on it in addition to income tax. The penalty is computed on Form 5329, and $2 will be transferred to Line 60 of Form 1040.

Attach a statement to your return explaining that the $4018.98 on the 1099R included a return of your 2006 Roth contribution of $4,000 and all earnings.

Mail in this return, it should not be electronically filed.

You also need Form 8606 on your return to record the nondeductible traditional IRA contribution. However, do not include the Roth IRA on Form 8606.

If this happens in a future year, you could convert the Roth to a traditional IRA in a trustee-to-trustee transfer and avoid tax and penalty on the earnings.