IRS Form 5329 Explained: How to Navigate Retirement Account Penalty Exemptions?
Personal TaxesThe money you invest in 401(k), traditional IRA, or 403(b) plans should stay in these savings accounts until you’re 59½. The IRS charges an early withdrawal penalty whenever you take money from your retirement account if the withdrawal doesn’t qualify for an exemption.
Learning to navigate retirement account penalty exemptions will enhance your retirement saving strategy while enabling you to take money from your retirement account without incurring penalties.
The 10% early withdrawal penalty doesn’t apply to Roth IRAs. But you must file IRS Form 5329 nonetheless if you receive an early distribution from this account during a tax year.
Let’s look at IRS Form 5329 and see how it can help you navigate retirement account penalty exemptions.
Table of Contents
A Quick Guide to Early Withdrawal Penalties
Deciding when to pay taxes is one of the most challenging decisions you’ll have to make when forging your retirement investment strategy.
Traditional 401(k) and IRA plans allow you to postpone paying taxes on the funds you put aside, while Roth IRAs are funded with post-tax money.
The IRS will charge a 10% penalty if you withdraw funds from a traditional 401(k) or IRA plan before you turn 59½. Moreover, you’ll have to file IRS Form 5329 with your tax return whenever you take money from these accounts.
Overfunding a 401(k) plan can also trigger a penalty, as you must withdraw or redistribute the excess funds. Here’s a quick overview of the contribution limits in 2023 for different retirement plans:
- Roth and traditional IRA – $6,500
- SARSEP and 401(k) – $22,500
- ESA – $2,000
- Simple IRA – $14,000
- Simple 401(k) – $15,500
The IRS allows you to request a corrective distribution with Form 1099-R before the filing deadline to avoid double taxation and additional penalties.
Retirement account holders older than 72 or 73 must pay harsh penalties for failing to make required minimum distributions.
Early Withdrawal Exemptions
The IRS offers several early contribution penalty exemptions that enable you to use the money in your retirement saving accounts without paying a 10% early withdrawal fee. You don’t have to pay the early withdrawal penalty if you use the funds for these purposes:
- IRS Levy: You can use the funds you invested in a retirement plan to settle a federal tax debt and lift a levy the IRS placed on your assets.
- Medical expenses: You won’t have to pay the early withdrawal penalty if you use the money for medical expenses exceeding 7.5% of your adjusted gross income.
- Health Insurance: The IRS allows you to make early distributions to cover health insurance costs while unemployed.
- Disability: Retirement plan contributors who become permanently disabled while investing in a plan don’t have to pay early withdrawal penalties.
- Death: The IRS won’t charge a 10% early withdrawal penalty in the event of the plan owner’s death.
- Military members: These penalties don’t apply on military reserves with more than 179 days of active duty.
- Disaster distributions: Early distribution tax doesn’t apply to withdrawals made due to a disaster.
- Substantially Equal Periodic Payments (SEPP): Distributions within SEPP plans are penalty-free if the payments are readjusted annually, tailored for the recipient’s life expectancy, and received after December 29, 2022.
The retirement account penalty exemptions apply to early withdrawals from IRA accounts if the funds are used to pay for higher education or purchase the plan holder’s first home.
The IRS doesn’t specify the maximum amount you can take to pay for tuition or other qualifying educational expenses such as the cost of room and board or the books you, your child, grandchild, or spouse need to complete higher education studies.
On the other hand, the maximum amount you can withdraw from a traditional IRA account to buy a home is $10,000 if your filing status is Single or $20,000 if you file a joint return with your spouse.
Recent Changes to Early Withdrawal Exemptions
The IRS introduced changes to the taxation of early distributions on December 30, 2022. These changes involve distributions to public safety employees who separate from the service after turning fifty or reaching 25 years of service with a retirement plan.
Firefighters who invest in private sector retirement plans, correction officers, or forensic security employees are exempt from this tax.
Starting from December 29, 2022, the IRS reduced excise tax from 50% to 25% for taxpayers who don’t make the required minimum distributions. According to Publication 590-B, taxpayers who meet the specific criteria can reduce excise tax to 10%.
Retirement account penalty exemptions also apply when:
- Terminally ill taxpayers receive distributions from ABLE, QTP, or Coverdell ESA accounts.
- Terminally ill taxpayers don’t receive the minimum required distributions from their qualified retirement plans.
It’s also worth pointing out that itemizing deductions isn’t necessarily to claim any retirement account penalty exemptions.
An Overview of IRS Form 5329
This two-page document has nine parts corresponding to contributions and distributions from different retirement accounts.
Its purpose is to report additional taxes from early withdrawals from IRAs, qualified retirement plans, QTPs, HSAs, ESAs, and similar accounts.
The first part of the form gathers general information about the distribution, and you’ll have to complete it to prove you’re eligible for early withdrawal tax exemption.
Subsequent parts of the document refer to distributions from different retirement accounts. You’ll only have to fill in the part referring to the plan you’re investing in and leave all other sections of the form empty.
You should attach a letter of explanation to IRS Form 5329 if you miss a required minimum distribution that covers why you didn’t make the distribution. Also, list the actions you’ll take to comply with the required minimum distribution requirements.
Remember that you’re not required to take MDRs before April 1 of the current tax year if you turned 70½ before December 31, 2019, reached 72 between January 1, 2020, and December 31, 2022, or if you were 73 as of January 1, 2023.
How and When to File IRS Form 5329?
You’ll have to file Form 5329 with a tax return whenever you receive an early distribution or fail to make a required minimum distribution, even if the withdrawal is exempt from the penalty.
In some cases, you can use Schedule 2 of Form 1040 instead of Form 5329 to report a 10% tax on an early distribution amount. Personal details are only necessary if you’re filing the form separately from your tax return.
It’s paramount to use Form 5329 for the appropriate tax year because you may face additional penalties if the version of the form you use doesn’t match the tax year in question.
You can file the form electronically or manually and submit it to the IRS with Form 1040 or Form 1040-SR before the filing deadline.
The form should include the exact distribution or excess contribution amount, correctly calculated tax, and, if applicable, exemption. Signing and dating the document isn’t necessary if you’re filing it with a tax return.
If you take Simple or Roth IRA distribution, you must include Form 8606 with Form 5329 and Form 1040. Taxpayers who overcontribute to their Archer MSA plans must file Form 8853 with the return and Form 5329.
Frequently Asked Questions
You can file a request to waive the penalty for overcontributing to a retirement plan if you can prove that the mistake was accidental and that you’re prepared to take the necessary steps to correct it.
The maximum amount you can withdraw from your retirement account without penalty depends on the purpose for which you want to use the money.
You can’t take more than $10,000 from a traditional IRA plan to purchase a home if you’re filing status is Single. At the same time, the maximum withdrawal amount for medical bills that exceed 7.5% of your AGI isn’t limited.
Both partners must file Form 5329 if they received early distributions from their retirement plans, even if they filed a joint return.
The IRS will assess additional penalties to your account if you don’t file Form 5329 after withdrawing funds from your retirement account, regardless of penalty exemption eligibility.
Using Retirement Account Penalty Exemptions to Maximize Your Savings
The funds you invest in a retirement plan should stay in your account until you reach the legal age to use them without penalties. However, unforeseen circumstances may force you to withdraw the money you’re saving for retirement early.
Being familiar with retirement account penalty exemptions available for your retirement plan will help you maximize savings and avoid unnecessary penalties.
Moreover, you should use Form 5329 to inform the IRS of an early distribution, overcontribution to a retirement plan, or failure to make a required minimum distribution to prevent them from charging additional taxes to your account.
We hope this article has helped you understand the purpose of IRS Form 5329 and made navigating retirement account penalty exemptions easier.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
