How the Wrong Code on IRS Form 1099 R Can Cause Heartache and Havoc

Who among you becomes happy when February arrives, and you receive your W-2 and/or 1099s? Anyone? Probably not.

Truth be told, the arrival of your W-2 and your 1099s (Misc Income) is like an annual visit from an annoying relative whom you wish would stay away from you. But that person is visiting you because they love you and think you’re wonderful. Unless you move to Tibet, how can you get out of this situation? You can’t. So, you give a forced smile and don’t make it look like a grimace.

If your relative is wealthy, then fake a big, beautiful smile and say, “How wonderful to see you! Thank you so much for coming all this way to visit us!” Why? C’mon, we’re all in the money business, I don’t need to paint a picture for you.

But I digress since this article is about 1099s. Believe it or not, as of 2018, there are sixteen different 1099 forms which are used to report different types of income. [1] So, the question occurs, which one can cause both heartache and havoc? Presumably, lots of them since there are subcategories under several types of 1099s.

Let’s take a look, shall we? Fear not, we aren’t going to plow through all sixteen. We’re only to investigate Form 1099 R. You won’t see this form a lot, but you will have clients who bring it to you. This form is coded from 1 to 11, and each number means something different. The link to the codes can be found below. [2]

And it is this form that I want to draw your attention to since it can cause lots of heartache, havoc and unnecessary expense. Which one is it? The 1099 R, which is issued when you take “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” [2]

Prior to age 59 ½, if you make a premature withdrawal from your Qualified Retirement Plan (QRP), the plan administrator will issue Form 1099 R to you, and you will pay a penalty of 10% of the amount you withdrew. Every 1099 R, however, has a specific numeric code from 1 to 11.[3] This is where a little bit of knowledge can make a major difference to your client.

How? Because the 10% penalty does not apply if you take early withdrawals because you are disabled. This is the definition of disability from the IRS:

“Section 72(m)(7) of the [IRS] Code provides that an individual shall be considered to be disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” [4]

If you meet this definition, you can make early withdrawals without penalty from a QRP and Individual Retirement Account (IRA). Here is the critical issue: you must insist the plan administrator issue a 1099 R (3). Three is the code number for disability. Whether you are the disabled person or you are representing the disabled person, you must be aware of this and be watchful that the plan administrator issues a 1099 R (3). In fact, you would be well served to have an attorney make this phone call or write a letter.

        If you fail to get the form coded 3, you will have to file your tax return, pay the penalty, then write a letter of appeal to the IRS to request a return of the 10% penalty. I have known people who did not know about the numeric coding of Form 1099 R; most people don’t. Hence, they did not ask for a 1099 R (3). Instead, they had to go the long route as explained.

        To be the trusted wealth advisor to a family, these are the small things you need to know because not knowing them can have major repercussions. This type of knowledge, as arcane as it sounds, can really be of help to your clients who at a younger age have become very ill.

[1] https://tinyurl.com/IRSlistingof1099s

[2] https://www.irs.gov/pub/irs-pdf/i1099r_16.pdf

[3] https://www.irs.gov/pub/irs-pdf/i1099r.pdf

[4] https://www.irs.gov/pub/irs-wd/1011036.pdf

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Contributing Writer: Subject Matter Expert Charles McCain