Many Taxpayers Dodged Penalty Tax for Early Retirement Withdrawals

Based on 2021 tax data, many taxpayers who took early distributions from tax-deferred retirement accounts did not pay the required 10% tax penalty or claim an exemption, according to a new report released by the Department of the Treasury’s inspector general for tax administration.

Approximately 6.2 million taxpayers indicated in tax forms that they took an early distribution from their retirement plan, totaling about $12.9 billion, but about 5.2 million taxpayers did not attach a Form 5329, indicating that they qualified for an exception to paying the 10% penalty.

In addition, about 3.1 million of the 5.2 million taxpayers did not self-report the 10% additional tax on their tax returns. Taxpayers taking an early distribution also have the option of moving their funds to other retirement accounts, known as a rollover. Of the 3.1 million taxpayers who did not report the 10% additional tax, 300,000 rolled over their funds to another retirement account.

The IRS applies a monthly “failure to file” penalty of 5% of the taxes owed for failing to file the Form 5329, according to the TIGTA. This means taxpayers could be subject to approximately $1.29 billion in collective additional taxes and approximately $322 million in Form 5329 failure to file penalties.

Without the Form 5329 failure-to-file penalty, the inspector general argued that there are potentially no consequences for taxpayers who take an early retirement distribution, do not pay the additional 10% tax and do not provide the IRS with any exceptions.

The TIGTA pointed out that the IRS has limited ability to identify noncompliance with early distribution penalties. The IRS must rely on post-processing procedures because some information returns are not due to the IRS until after most tax returns have already been processed. For example, retirement plan providers need to file Form 1099-R with the IRS by March 31 of the following tax year, so these forms are generally not available when most tax returns are filed.

The inspector general made several recommendations to the IRS to improve compliance with early retirement distribution regulations.

As one of the recommendations, the TIGTA suggested that the small business/self-employed division at the IRS work with the IRS office of chief counsel to establish guidance for the applicability and computation of the failure-to-file penalty for delinquent Form 5329s. The IRS partially agreed with this recommendation, concurring that improving Form 5329 filing compliance would increase the efficiency of its compliance activities and reduce taxpayer burden. It also agreed to identify opportunities to remind affected stakeholders of Form 5329 filing requirements.

However, the IRS disagreed with the inspector general’s recommendation to amend its Automated Underreporter program to include alerting taxpayers who potentially have not filed or paid the taxes related to early retirement distributions. The agency argued it already includes these taxpayers in its AUR notice program, and taxpayers who are potentially not complying with early distributions are already included in the AUR function’s inventory and are subject to “traditional AUR compliance action.”

In its analysis, TIGTA found that approximately 2.3 million taxpayers did not properly report a combined $11.4 billion in early distributions as taxable income, including 880 taxpayers who each took distribution amounts in excess of $200,000.

As a result, the TIGTA recommended that the IRS review a sample of tax returns in which taxpayers had early distributions greater than $200,000, did not pay the additional 10% tax and failed to file Form 5329 to determine the appropriate compliance treatment. However, the IRS disagreed with this recommendation, arguing again that it already has a system in which these types of cases are reviewed and selected.

“Many early distributions are rollovers or are otherwise excepted from the additional tax and are screened out during the IRS’s preliminary review,” IRS management stated. “During the audit, the IRS reviewed a sample of these cases and determined that these cases were properly non-selected in favor of more productive work.”