10.1 10% Early Distribution Tax Exceptions (Form 5329), Excess Contributions & IRA Prohibited Transactions

Why This Topic Matters

Part 1 tests early distributions from two directions: the preparer must decide whether a Form 1099-R distribution is subject to the 10% additional tax, and the adviser must steer a client toward the exception that fits. Box 7 of Form 1099-R often shows Code 1 (early distribution, no known exception) even when the taxpayer qualifies for an exception the payer could not verify, so the return must claim that exception on Form 5329.

The 10% Additional Tax Under IRC §72(t)

The additional tax equals 10% of the taxable portion of a distribution made before the owner reaches age 59½. It applies to traditional IRAs, SEP and SIMPLE IRAs, 401(k), 403(b), and other qualified plans, and to the taxable earnings in a nonqualified Roth IRA distribution. Nontaxable amounts, such as after-tax basis recovered under the Form 8606 pro-rata rule or Roth contributions, are never penalized.

• SIMPLE IRA: The rate rises to 25% for distributions within the first 2 years of participation.
• Governmental 457(b) plans: Not subject to the 10% tax at all (unless the amount is attributable to a rollover from another plan type).
• Reporting: The tax is figured in Part I of Form 5329 and carried to Schedule 2, Line 8. If Form 1099-R shows Code 1 but an exception applies, the taxpayer enters the exception number on Form 5329. If Code 2, 3, or 4 already shows the exception, Form 5329 is usually unnecessary.

The Exceptions Map

Exam trap: A 56-year-old who retires and takes money from her former employer's 401(k) owes no 10% tax, but the same person who first rolls the money to an IRA and then withdraws it does owe the tax because the age-55 exception does not apply to IRAs. Conversely, a 45-year-old who pays college tuition from an IRA avoids the tax, but the same withdrawal from a 401(k) is penalized.

Worked Example: Partial Exceptions

Dana, age 52, withdraws $30,000 from her traditional IRA (no basis) in 2025. Her AGI including the withdrawal is $80,000. She used $8,000 for her own graduate tuition and paid $9,000 of unreimbursed medical bills.

1. Higher education exception: $8,000 excepted.
2. Medical exception: only the excess over 7.5% of AGI, $9,000 - $6,000 = $3,000 excepted.
3. Amount subject to the additional tax: $30,000 - $8,000 - $3,000 = $19,000.
4. Additional tax on Form 5329: $19,000 x 10% = $1,900, in addition to regular income tax on the full $30,000.

Excess Contributions: The 6% Excise Tax (IRC §4973)

An excess contribution is any amount contributed above the annual limit, above the taxpayer's taxable compensation, or to a Roth IRA when MAGI is too high. The excess is taxed at 6% for each year it remains in the account at year-end, figured in Form 5329 Parts III and IV. The same 6% tax applies to excess HSA, Coverdell ESA, and ABLE contributions.

Ways to correct an excess IRA contribution:

• Withdraw it with its net income attributable by the due date of the return including extensions. The excess is not taxed again, the earnings are taxable in the year the contribution was made, and since SECURE 2.0 the earnings are not subject to the 10% additional tax.
• Recharacterize a Roth contribution as a traditional IRA contribution (see the rollovers section).
• Absorb it by treating the excess as a contribution for the following year, paying the 6% tax for the year it was in excess.

Example: Lucas contributed $7,000 to a Roth IRA for 2025 but had only $4,500 of wages. The $2,500 excess costs $150 (6%) for 2025, and again each later year, unless he withdraws $2,500 plus its earnings by October 15, 2026.

Prohibited Transactions With an IRA (IRC §4975)

An IRA owner may not use the account for personal benefit. Prohibited transactions involve the IRA and a disqualified person: the owner, the owner's spouse, ancestors, lineal descendants and their spouses, and any fiduciary. Common examples:

• Borrowing money from the IRA (IRAs cannot make loans to the owner);
• Selling property to, or buying property from, the IRA;
• Using the IRA as security for a loan;
• Buying a vacation property in the IRA and letting the family use it;
• Paying the owner a fee for managing IRA-owned property.

Consequence: If the owner (or beneficiary) engages in a prohibited transaction, the account ceases to be an IRA as of January 1 of that year. The fair market value of all its assets on that date is treated as distributed, is taxable, and is subject to the 10% additional tax if the owner is under 59½. If only part of an IRA is pledged as security, just the pledged portion is treated as distributed. An IRA's purchase of collectibles (art, rugs, antiques, gems, most coins) is also treated as a distribution of the amount invested, except for certain U.S. gold, silver, and platinum coins and qualifying bullion held by the trustee.