IRS-Levied Retirement Funds and the 10% Penalty Exception

Most people in their 50s who owe the IRS have thought about it: take money out of the 401(k), pay the IRS, be done with it. Then someone mentions the 10 percent early withdrawal penalty and the math gets ugly.

Here is a fact that surprises people. If the IRS takes the money by levy, there is no 10 percent additional tax. If you take it yourself, there usually is. Same account, same debt, different result.

The statutory exception

IRC 72(t)(1) imposes an additional tax equal to 10 percent of the taxable portion of a distribution from a qualified retirement plan, which section 4974(c) defines to include 401(a) plans, 403(a) and 403(b) annuities, and IRAs. Section 72(t)(2)(A) lists distributions that are exempt. Clause (vii) covers distributions "made on account of a levy under section 6331 on the qualified retirement plan."

The IRS lists the levy exception on its own table of exceptions to the early distribution tax, and it applies to both employer plans and IRAs.

The exception only removes the 10 percent additional tax. The distribution is still taxable income under IRC 72 and 408(d)(1). IRM 5.11.6.3 says it directly: there may still be income tax owed for the amount withdrawn.

Why voluntary withdrawals do not qualify

The words "on account of a levy" do the work. A withdrawal you choose to make, even if every dollar goes to the IRS, is not made on account of a levy. Neither is a withdrawal made because you received a levy notice on a different asset, or a notice of intent to levy, or because a Revenue Officer suggested you use the account. The exception is read literally: the IRS must actually levy the retirement account.

So the person who takes $40,000 from a 401(k) at age 54 to pay the IRS typically owes income tax on $40,000 plus a $4,000 additional tax. If the IRS levied the same $40,000, the $4,000 would not apply.

The taxpayer-requested levy

Here is the part most people miss. The Internal Revenue Manual lets a taxpayer ask the IRS to levy their retirement account. IRM 5.11.6.3 says that if the taxpayer provides a signed written request asking the IRS to levy the assets in a retirement account, the IRS considers the request as part of the ability-to-pay determination.

When the request comes from the taxpayer, the Revenue Officer still considers alternatives and whether you need the funds for living expenses, but does not make the flagrant conduct determination, because you asked. The request is documented on Form 15000 and still requires approval. Before issuing the levy, the IRS verifies you received Collection Due Process rights. If you want a second account levied, you must make a second written request.

Why would anyone ask to be levied? Because when it makes sense to use retirement money to resolve the debt, a levy avoids the 10 percent additional tax that a voluntary withdrawal would trigger. For someone under 59 and a half with a large balance, that can be meaningful money.

When a requested levy makes sense

• You are under 59 and a half, so the 10 percent tax would otherwise apply.
• You have decided, after weighing alternatives, that paying from the retirement account is the right move.
• You do not need the account for living expenses in the near future.
• Your case is assigned to a Revenue Officer, who handles these requests. If your case is still in the Automated Collection System, ask how a written request will be routed.

If you are already 59 and a half, there is no 10 percent tax to avoid, and a voluntary withdrawal is simpler. See should you cash out your IRA to pay the IRS?

An example in numbers

Say a 56-year-old in Clearwater owes the IRS $40,000 and has $150,000 in a 401(k) from a former employer. She has decided, with advice, that using part of the account is the right answer. If she withdraws $50,000 herself, she owes income tax on $50,000 plus a 10 percent additional tax of $5,000. If the IRS levies $50,000 at her written request, she owes the income tax but not the $5,000. Florida has no state income tax, so there is no state-level penalty to think about either way. The federal difference alone is real money. The figures are illustrations; the right amount to use, if any, depends on the rest of her finances.

Reporting a levy distribution

The IRS sends Letter 3257 to the plan administrator and Letter 3258 to you with the levy. Both state that the 10 percent additional tax on early distributions is not due because the withdrawal was made by levy. Keep your copy.

The plan reports the distribution on Form 1099-R. If box 7 shows code 2, which indicates an early distribution with a known exception, you report the taxable amount as income and nothing more. If the payer used code 1, early distribution with no known exception, you claim the exception yourself on Form 5329, using the exception number for IRS levies listed in the Form 5329 instructions. Otherwise the IRS's matching system will assume the 10 percent applies and send a notice. See Form 1099-R distribution codes that trigger IRS notices.

If you are close to 59 and a half

Timing can make this whole question disappear. The 10 percent additional tax does not apply to distributions made on or after the date you reach 59 and a half, under IRC 72(t)(2)(A)(i). If you are a few months away, a short-term payment plan or an installment agreement that bridges you to that date may cost less than either a voluntary early withdrawal or the paperwork of a requested levy. Run the interest and penalty cost of waiting against the 10 percent you would save.

Withholding on levied funds

The payor withholds federal income tax on the distribution, and the levy reaches only what remains. IRM 5.11.6.3 cites IRC 3405(c) and gives an example: on a $5,000 plan balance, $1,000 is withheld and $4,000 goes to the IRS. The withheld $1,000 is credited on your return as tax paid. Depending on your bracket, it may cover the income tax on the distribution, or you may owe more or get some back.

The income tax still has to be paid

Do not let the levy create a new balance. If the withholding is not enough to cover the tax on the distribution, make an estimated payment or adjust other withholding. A new unpaid balance can default an installment agreement or reopen collection. See estimated tax penalties for new retirees.

The SECURE 2.0 exceptions are different

Recent law added other exceptions to the 10 percent tax, including a once-a-year emergency personal expense distribution of up to $1,000 and distributions to terminally ill individuals. None of them are designed for paying the IRS, and a $1,000 cap will not solve a real tax debt. The complete list is in the 10% early withdrawal penalty: exceptions that actually apply.

Next step

If you are under 59 and a half, owe the IRS, and are thinking about using retirement money, talk to someone before you withdraw. A requested levy may save you the 10 percent. Call (813) 229-7100. The firm's page on IRS tax levies explains how levies work generally.