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 paying more taxes than you owe or owing to the IRS an excise penalty for which you are exempted.
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 they owe the IRS the 10% early-distribution or another penalty. The following are some transactions that may require the filing of Form 5329.
An individual who receives a distribution from their retirement account before reaching age 59½ 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 Form 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 the IRA. 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 the 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 their 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 2 of Form 5329.
For Roth IRAs, Form 5329 may need to be coordinated with Form 8606 to determine the amount of the distribution that is subject to the early distribution penalty.
Early Withdrawals and the CARES Act
The passage of the CARES (Coronavirus Aid, Relief, and Economic Security) Act in March 2020 allows for early withdrawals form 401(k) and individual retirement accounts (IRA) penalty-free. These hardship withdrawals can be taken if the account holder is affected by the COVID-19 pandemic. The amount that can be withdrawn penalty-free is up to $100,000.
An individual may contribute the lesser of 100% of eligible compensation or $6,000 ($7,000 if at least age 50 by year-end) to an IRA for both 2020 and 2021. 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 the tax-filing deadline (plus extensions) for IRAs and by June 1 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 3 should be completed; for Roth IRAs, Part 4; and for ESAs, Part 5 should be completed.
A retirement account owner must begin taking required minimum distribution (RMD) amounts from his or her retirement account by the required beginning date and for every subsequent year.
Starting in 2020, the latest age for RMDs is 72 years old. Prior to 2020, it was 70½ years old. The retiree must then withdraw the RMD amount each subsequent year based on the current RMD calculation.
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.
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. If you believe you qualify for this relief, consult with your tax professional for assistance with requesting the waiver from the IRS.
Paying Penalties and Filing Forms
Your IRA custodian or plan trustee 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. Penalties must be paid directly to the IRS, and are usually included on your tax return or applicable tax forms.
These forms must be filed by the individual's due date for filing their tax return, including extensions. If the form is being filed for a previous tax year, the form applicable to that tax year should be used. Failure to use the form for the applicable tax year may result in the penalty being applied to the wrong year.
The proper completion and filing of all applicable forms are an important part of the tax-filing process. Individuals should consult with their tax professional for assistance with completing and filing the appropriate forms.
The Bottom Line
You do not want to pay the IRS more taxes or penalties than you owe, nor do you want the IRS to determine 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.