Does the use of form 5329 result in more inquiry letters from the IRS.

Submitted by Tim Escott on Thu, 2018-03-15 15:38

Our firm uses Charles Schwab as Custodian. For the last 5 years Schwab does not allow a code 2 exception election on its IRA distribution form. They put code 1 on the 1099 and direct you to file form 5329 to get the exception. At the moment, the CPA of one of my clients is insisting that the 5329 will increase the likelihood of an inquiry letter and is insisting Schwab issue a “Correct” 1099-R. The CPA is highly respected and I have no desire to battle with him, but Schwab will not issue a new 1099-R with code 2. Is there any information or data you can provide that would help me put the CPA’s mind at ease about using the 5329? He insists that no other custodian uses the “Code 1 / 5329” method of reporting and is making a big issue of this to my client. I would like to show him that this approach is fairly common and is not expected to result in greater scrutiny. Help!

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Permalink Submitted by Alan - IRA critic on Thu, 2018-03-15 16:24

I assume you are referring to a SEPP plan exception. Actually, Schwab was one of the last major custodians to provide the 2 code after underwriting the accuracy of the SEPP calculation as much as possible. Vanguard has not provided the 2 code for many years. Currently, my guess is that less than 20% of 1099R forms for SEPP distributions bear the 2 code. Therefore, it has become so routine that filing a 5329 to indicate exception code “02” that it is no longer a red flag to the IRS. The audit frequency increase for the 5329 vs. the 2 code is probably less than 4%. Therefore, the CPA has really overstated this issue, particularly when he states that “no other” custodian uses Code 1. That was not even correct 15 years ago. Further, since Schwab held out longer than most of the others in making a policy change to Code 1, they are not going to change their mind unless this client has a massive amount of assets with Schwab, such that Schwab is willing to totally review all aspects of his plan, the original calculations etc.
Posters to the major 72t site do not report any particular added scrutiny and almost all of them have had to file a 5329. The owner operator of the site confirms that this is not an issue and hasn’t been in recent years.
The reasons for the custodian change of policy is that 72t IRS tax oversight is done without formal Regs and beyond RR 2002-62, the interpretations have come through tax court decisions and several PLRs, some of which were not even consistent. Further, more plans include more than one account, partial transfers of IRAs during the plan, changes of custodians, switches to the RMD method etc. It is expensive for custodians to continue to underwrite plan validity under these circumstances and they do not want to issue Code 2 unless they are sure it is accurate. They want to leave the interpretation of plan compliance between the taxpayer and the IRS.

Permalink Submitted by Tim Escott on Thu, 2018-03-15 16:51

My case is a 72t election, but you mention that in your second bullet point. If there is anything else you think is pertinent for the 72t please let me know but I’m hoping this has it covered. Thank you.

Permalink Submitted by Alan - IRA critic on Thu, 2018-03-15 17:33

A 72t plan is the same as a SEPP (substantially equal periodic payments), so two terms with the same meaning.

Permalink Submitted by Tim Escott on Thu, 2018-03-15 17:57

Perfect.