ProSeries Professional somehow knows that the retirement withdrawal is subject to section 72(t) and for the Fed automatically only make 1/3rd taxable the first year and even though there is a code 1 knows the withdrawal is not subject to a 10% penalty. This is what section (t) says to do.
The problem lies with the states which if code 1 is used makes the withdrawal 100% taxable. If Code 2 was used then none of the withdrawal would be taxable. Someone in the IRS has deemed that code 2 is for this situation. If the institutions would use code 2 then none of this is taxable to the states.