In most cases, the only way to receive the proper tax treatment for your income, including income you receive as a distribution from your retirement plan or education savings account (ESA), is by filing the proper forms. In fact, failure to file the appropriate form could result in you paying more taxes than you owe or owing the IRS an excise penalty. In this two-part series we give an overview of some important forms you should know about.

IRS Form 5329
Form 5329, entitled "Additional Taxes on Qualified Retirement Plans (including IRAs) and Other Tax-Favored Accounts", is filed when an individual with a retirement plan or ESA needs to indicate whether he/she owes the IRS the 10% early-distribution or other penalty. The following are some transactions that may require filing of Form 5329.

Early Distributions
An individual who receives a distribution from his or her retirement account before reaching age 59.5 owes the IRS an early-distribution penalty (additional tax) of 10% of the distributed amount, unless an exception applies. Generally, the issuer (the IRA or ESA custodian or qualified plan administrator) will indicate on Form 1099-R (used for qualified plans and IRAs) or 1099-Q (used for education savings accounts and 529 plans) whether the distributed amount is exempt from the early-distribution penalty. If an exception to the early-distribution penalty applies, the issuer should note it in Box 7 of Form 1099-R.

Sometimes, for various reasons, the issuer may not make the proper indication on the form. Say for instance, an individual received distributions via a substantially equal periodic payment (SEPP) program from his or her IRA in 2003. However, instead of using code 2 in Box 7 of Form 1099-R, the issuer used code 1, which means that no exception applies. This could lead the IRS to believe the amount reported on the Form 1099-R is not part of the SEPP; consequently, it appears that the individual has violated the SEPP program and now owes the IRS penalties plus interest on all past distributions that occurred as part of the SEPP. Fortunately, the individual is able to rectify this error by filing Form 5329.

The following are some of the other circumstances that require the individual taxpayer to file Form 5329:

• The individual receives a distribution from his/her retirement plan that meets an exception to the early distribution penalty, but the exception is not indicated on Form 1099-R. The individual must complete part l of Form 5329.
• The individual receives a distribution from his/her retirement account that does not meet any exception to the penalty. However, the issuer mistakenly indicates that an exception applies. The individual must complete part l of Form 5329.
• The individual receives a distribution from an education savings account (ESA). However, the amount was not used for eligible education expenses and the individual does not meet an exception to the early distribution penalty. The individual should complete part ll of Form 5329.

Note: For Roth IRAs, Form 5329 must be coordinated with Form 8606 to determine the amount of the distribution that is subject to the early distribution penalty.

Excess-Contribution Penalty
An individual may contribute the lesser of 100% of eligible compensation or $4,000 ($5,000 if at least age 50 by year-end) to an IRA for 2007 the tax year. For ESAs, the contribution is limited to $2,000 per year for each beneficiary (ESA owner). Contributions in excess of these amounts must be removed from the account by tax-filing deadline (plus extensions) for IRAs and by June 30 of the following year for ESAs. An amount not removed by this deadline may be subject to a 6% excise tax for each year the excess amount remains in the account. The applicable section of Form 5329 is determined by the type of account: for Traditional IRAs, part lll should be completed; for Roth IRAs, part lV; and for ESAs, part V should be completed.

The 6% excise tax may also apply to ineligible rollovers, ineligible transfers and excess SEP contributions, unless they are corrected in a timely manner.

Excess-Accumulation Penalty
A retirement account owner must begin taking required minimum distribution (RMD) amounts from his or her retirement account by his/her required beginning date and for every subsequent year. This rule applies to Traditional, SEP, and SIMPLE IRAs, qualified plans, 403(b) plans and eligible 457 plans. Failure to remove the RMD amount will result in the individual owing the IRS an excess-accumulation penalty, which is 50% of the amount needed to meet the RMD requirement.

For example, if your RMD from your Traditional IRA is $5,000 for the year and you distribute only $2,000 by the deadline, you will owe the IRS a $1,500 excess accumulation penalty, which is 50% of the $3,000 you failed to distribute. You must then complete part Vlll of Form 5329 to declare the penalty.

Note: According to the instructions for filing Form 5329, the IRS may waive this tax for individuals who can show that the shortfall was due to reasonable error and that they are taking appropriate steps to remedy the shortfall. An individual believing he or she qualifies for this relief must file Form 5329, pay the tax, and attach a letter of explanation to the form. If the IRS waives the tax, the amount will be refunded.

Paying Penalties and Filing Forms
Penalties, which are in addition to any applicable income tax, must be paid to the IRS. Your payer is unable to pay the penalty on your behalf. Therefore, when submitting a distribution request, you should elect to have amounts withheld only for federal and state tax, if applicable.

These forms must be filed by the individual's due date for filing his/her tax return, including extensions. If the form is being filed for a previous tax year, the form applicable to that tax year must be used. Failure to use the form for the applicable tax year may result in the penalty being applied to the wrong year.

Proper completion and filing of applicable forms is an important part of the tax-filing process. Individuals should consult with their tax professional for assistance with completing and filing the appropriate forms.

Conclusion
You do not want to pay the IRS more taxes or penalties than you owe, nor do you want the IRS determining that you failed to pay penalties, which means you will have to pay interest on the amount you owe. Understanding when you need to file Form 5329 is a critical step in ensuring that you meet your tax obligations. Be sure to read the instructions and contact your tax professional with any questions you have about filing the form. For additional information, you may also read IRS Publication 590, available at www.irs.gov. In part 2, we look at Form 8606, which has become increasingly important with the introduction of the Roth IRA.
 

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.