How the IRS Knows You Owe Retirement Penalties (Early Withdrawals, Excess Contributions & Missed RMDs)

The IRS isn’t sitting around reading your brokerage statements line by line. What they actually do is simpler—and way more effective.

They match what banks and custodians report about you with what you put on your tax return, and when something doesn’t line up, the computer gets curious.

That’s where Form 5329 quietly enters the picture.

someone files their return, everything seems fine… and then months later a CP2000 notice shows up asking for penalties they didn’t expect.

This article is about why that happens, to keep you from getting surprised later.

The “Snitch” Forms the IRS Already Has

Any time money moves in or out of retirement or tax-favored accounts, a third party reports it – Those forms go straight to the IRS.

Here are the big ones:

Form 1099-R – Distributions from:

• IRAs
• 401(k)s and 403(b)s
• Pensions and annuities

Form 5498 – Contributions and year-end balances for:

• Traditional IRAs
• Roth IRAs
• SEP and SIMPLE IRAs
  (Also flags whether an RMD is required)

Form 1099-SA / 5498-SA – For:

• HSA and Archer MSA contributions and distributions

Form 1099-Q / 1099-QA / 5498-QA – For:

• 529 plans
• Coverdell ESAs
• ABLE accounts

You get copies of these forms.
The IRS gets copies too—and theirs feed directly into matching software.

The IRS’ internal question is basically:

“We see money moving around.
Does the tax return explain this… or not?”

Early Distributions: The Easiest Thing for the IRS to Catch

This is the most common and the most automatic.
Everything hinges on Box 7 of Form 1099-R.

A few important codes:

• Code 1 – Early distribution, no known exception
• Code 2 – Early distribution, exception applies
• Code 7 – Normal distribution (59½ or older)

When the IRS sees Code 1, they know one thing for sure:

You took money out before age 59½.

From there, they expect to see one of two things on your return:

• A 10% early withdrawal penalty, or
• A Form 5329 explaining why that penalty doesn’t apply

Example I see all the time:
You cash out a $12,000 401(k) when changing jobs.
The 1099-R shows Code 1.
You report the income… but forget about the penalty or Form 5329.

From the IRS’ point of view:

• Early distribution ✔
• Income reported ✔
• Penalty or explanation 🙁
  

That’s when the computer says, “Okay, then you owe the penalty.”

A CP2000 notice follows, usually assuming the entire amount is subject to the 10% penalty.

Form 5329 is where you say:

“Yes, I took money out early—but here’s why the penalty doesn’t apply.”

If you never file it, the IRS has no reason to give you the benefit of the doubt.

Excess Contributions: Quieter, But They Add Up

Excess contributions don’t always get caught right away, but they leave a paper trail.

The IRS can see:

• How much you contributed (Form 5498 / 5498-SA)
• What type of account it went into
• Your age, income, and filing status
• The legal contribution limits for that year

They can compare what you were allowed to contribute versus what custodians say you actually did.

If there’s an excess, the penalty is:

• 6% per year, every year the excess sits there

Example:
You put $8,000 into a Roth IRA.
Later you realize your income was too high to contribute at all.

That excess doesn’t just go away.
It quietly generates a 6% penalty every year until it’s fixed—and Form 5329 is how that penalty gets reported and tracked.

In real life:

• Small overages sometimes slip through initially
• Big, obvious excesses are more likely to get noticed
• HSAs are similar—large contributions without HDHP coverage tend to stand out

Most people don’t find out from the IRS first.
They find out later when a tax pro reviews prior returns or when something finally doesn’t add up.

Missed RMDs: Not Loud, But Definitely Visible

Required Minimum Distributions are another common Form 5329 issue.

The IRS can see:

• Year-end IRA balances (Form 5498)
• Whether an RMD is required
• Your age
• What you actually withdrew (1099-Rs)

So if you’re over RMD age, have IRA balances, and the distributions look light—or nonexistent—the question becomes obvious.

Example:
You hit RMD age, had an IRA, and simply didn’t know you were supposed to take anything out.

This usually doesn’t trigger an instant notice, but it can surface later.

When it does, Form 5329 is where:

• You report the missed amount, and
• You request a waiver if the mistake was reasonable and corrected
  

Penalties have changed over time, but the process hasn’t:
Form 5329 is still the form that handles it.

If you never file it and the IRS catches the issue first, they start from:

“Here’s what we think you owe.”

HSAs, 529s, ESAs, ABLE Accounts: Same Pattern, Different Labels

All other tax-favored accounts work the same way:

• Custodians report contributions and distributions
• You file your return and related forms
• The IRS checks whether distributions look qualified

If money comes out and:

• There’s no additional tax reported, and
• No Form 5329 explaining why…

That’s how you end up in notice territory.

So How Does the IRS Actually “Know” Form 5329 Was Required?

They don’t.
At least not directly.
What they know is:

• What third parties reported
• What your tax return shows
• What should have happened under the rules

When those don’t line up, the system assumes:

“An additional tax probably applies—and we don’t see it.”

Form 5329 is how you say:

“There’s more to this story.”

If you don’t say anything, the IRS fills in the blanks themselves.

Why Filing Before They Ask Matters

Waiting for the IRS to notice is almost always the worst way to handle this.
If you file Form 5329 proactively:

• You control the numbers
• You claim exceptions correctly
• You can request penalty waivers
• You look like someone fixing a mistake—not hiding one

You can:

• File Form 5329 by itself for past years, or
• File Form 1040-X plus Form 5329 if the return also needs changes

If you wait:

• The IRS assumes full penalties
• Exceptions aren’t assumed
• Interest is already running by the time you respond

Rule of Thumb

If any of this sounds familiar:

• Early IRA or 401(k) withdrawal
• Over-contributed to an IRA, Roth, or HSA
• Missed or underpaid an RMD
• Took distributions from HSAs, 529s, ESAs, or ABLE accounts

…assume Form 5329 is part of the conversation, whether you like it or not.

You can either ignore it and hope nothing happens, or use it for what it actually is:

A calculator.
An explanation.
And sometimes, a second chance.

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