Millions of Americans avoided paying taxes on early retirement distributions

Whether it's the soaring costs of living, surging debt, or to address emergency expenses – the devastating impact from Hurricane Helene and Hurricane Milton in the Southeastern US comes to mind – millions of Americans have had to dip into their nest eggs earlier than expected. But whether it's accidental or not, many people accessing their retirement accounts early are also hitting a critical tax tripwire, according to a report from the Treasury Inspector General for Tax Administration.

In a recent audit report, TITGA found that millions of taxpayers who took early withdrawals from retirement accounts in 2021 failed to pay the required taxes and penalties.

The report, issued on September 30, reveals that around 2.8 million taxpayers who withdrew a total of $12.9 billion in early retirement distributions neither paid the 10 percent additional tax nor filed the necessary paperwork to claim exemptions.

Under US tax law, early withdrawals from retirement plans like IRAs and 401(k)s before the age of 59½ are generally subject to a 10 percent penalty unless the taxpayer qualifies for an exemption. But to claim an exemption, individuals must file Form 5329, which also alerts the IRS to the distribution. In 2021, many taxpayers didn't file that paperwork, resulting in an estimated $1.29 billion in unpaid taxes and $322 million in potential penalties.

In theory, taxpayers who failed to file the form 5329 would automatically be obligated the 10 percent penalty on the additional income tax owed from their early withdrawals on the day their tax return is due. But the reality's not so simple for IRS management, the report said, as "taxpayers who belatedly file Forms 5329 are claiming exceptions to the tax and the subsequent amount owed is potentially zero, rendering the penalty amount to zero."

Adding to the taxman's inability to fully enforce compliance, the report said the IRS's Automated Underreporter function identified discrepancies in only 371,000 cases. Beyond that, TIGTA’s analysis found more than 2.3 million taxpayers also failed to report a combined $11.4 billion in early distribution income.

Some of the most severe oversights were seen among high-net-worth individuals, with nearly 1,000 taxpayers withdrawing amounts exceeding $200,000 without reporting the taxable income or penalties. The report points to the IRS’s resource constraints – which it's somewhat addressed as far as its campaign to collect back taxes from high-income individuals – and lack of timely third-party information as key barriers to closing the tax collection gap.

While the IRS has agreed to several recommendations, including updating guidance on how penalties are applied and enhancing taxpayer education, it has pushed back against some measures, citing concerns over resource allocation. TIGTA emphasized that better enforcement could potentially yield over $1.6 billion in additional revenue over the next five years.

All in all, the report underscores a growing concern for financial advisors, particularly as more Americans dip into their retirement savings early. The findings could prompt stronger IRS enforcement and increased scrutiny on early withdrawals, making it critical for advisors to ensure clients fully understand their tax liabilities when accessing retirement funds early.

“Without proper oversight, taxpayers who fail to pay the additional tax or file the required forms face little consequence, putting billions of dollars in potential revenue at risk,” the report concluded.