Why wouldn't you be subject to an early withdrawal penalty? You would be subject to a 20% early withdrawal penalty, except for the reasons below
You've resurrected a 3 year-old post—that poster has already dealt with his problem a long time back and won't likely see your response. However, now that you've bumped the post up, let me answer the question to relieve any confusion this thread might create.
First, if a distribution is taken from a qualified plan before age 59 and half, there is imposed an early distribution tax (which the public often calls an "early withdrawal penalty") of 10% (not 20%) for distributions that are not qualified distributions—meaning that they don't meet one of the exceptions to the early withdrawal tax (e.g. disability, death, etc). This assumes that the 5 year period from the date the traditional IRA was converted has passed, as it did in the original poster's case.
But it's important to understand that the early withdrawal tax is imposed only on the portion of the distribution that is includible in income. See IRC § 72(t)(1) and Treas. Reg. § 1.408A-6, Q&A 5. With a traditional IRA, generally ALL the distribution is included in income, which is why any early withdrawl tax also applies the entire distribution with a traditional IRA. That has lead a lot of folks to think the same is true of the Roth IRA. But unlike the traditional IRA, not all of the Roth IRA is included income. With the Roth, the amount you contributed is distributed back to you tax free because you paid tax on that the year you contributed it. The funds put into a traditional IRA are effectively not taxed the year you contribute them because of the deduction you get, which is why all generally all the distribution of a traditional IRA is included in your income.
If the basis of the Roth IRA started out at $40,000 and then the account value dropped to $7,000, then the entire distribution is a return of contributed funds (basis) and none of it is included in your income if you liquidate the Roth at that point. If that distribution was not a qualified distribution, then technically the early withdrawal tax does apply, but since the tax is computed at 10% of the taxable portion of the distribution, the early withdrawal tax works out to be zero (zero taxable distribution x 10% = zero). IRS publication 590 for 2009 does tell you this in the Roth IRA section, stating "Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any
distributions that are not qualified distributions." (bolding added). That word "taxable" is key, but often overlooked by folks.
In short, the responses by D. Greenleaf several years ago to the original poster were the correct answers.