Fidelity’s 1099-R Has a One-Letter Code in Box 7 That Tells the IRS Whether You Owe a 10% Early Withdrawal Penalty. Code 1 Means You Do, Code 2 Means You Don’t, and Form 5329 Is How You Overrule the Custodian When It’s Wrong
Most people glance at the dollar amount on their 1099-R and move on, but a single letter buried in Box 7 quietly decides whether they owe the IRS thousands of dollars more than they should.
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Every January, anyone who took money out of a retirement account the year before gets a Form 1099-R. Most people check the dollar figure in Box 1 and file the form away. The detail that matters more sits a few inches lower: a single character in Box 7.
That character tells the IRS how the money left your account. If you’re under 59½, two codes matter most. Code 1 means an early distribution with no known exception, which flags you for the 10% additional tax. Code 2 means an early distribution where an exception applies. If the custodian picks the wrong code, you fix it yourself on Form 5329.
What Box 7 Code 1 and Code 2 Tell the IRS
Fidelity Investments and every other custodian follow the same IRS rules. The 2026 Instructions for Forms 1099-R tell payers to use code 1 only if the participant has not reached age 59½, and you do not know if any of the exceptions apply. Code 2 marks an early distribution, exception applies.
The penalty comes from 26 U.S.C. § 72(t)(1). That section increases your tax by 10% of the portion of such amount which is includible in gross income, on top of ordinary income tax.
The key word is “know.” An IRA custodian sees your birthdate and your withdrawal amount. It can’t see your hospital bills or your disability paperwork. That’s why code 1 is the default for most IRA withdrawals before 59½, even when the law says you owe nothing extra.
How Code 1 Can Overcharge a 54-Year-Old by $2,750
Here’s an example case. A 54-year-old single filer takes $40,000 from her Fidelity traditional IRA in 2026 to cover $35,000 in unreimbursed medical bills after surgery. Her 2026 adjusted gross income (AGI), including the withdrawal, is $100,000. Her 1099-R shows code 1.
If she files the form as it as is, the IRS expects a $4,000 penalty. But IRS Publication 17 makes an exception for unreimbursed medical expenses that are more than 7.5% of your AGI. The exception covers only the expenses above that floor, and she doesn’t have to itemize to claim it.
| 2026 line item | Amount |
|---|---|
| Taxable IRA distribution | $40,000 |
| Medical floor (7.5% of $100,000 AGI) | $7,500 |
| Medical costs above the floor (exempt) | $27,500 |
| Amount still subject to the penalty | $12,500 |
| Penalty with Form 5329 | $1,250 |
| Penalty if code 1 goes unchallenged | $4,000 |
| Savings | $2,750 |
She still owes regular income tax on the full withdrawal. The exception removes only the extra 10% on the protected part.
Form 5329 Lets You Overrule the Custodian
Publication 575 lays out both ways. If you owe the penalty and your 1099-R correctly shows code “1” in box 7, you can skip Form 5329. You report 10% of the taxable amount directly on Schedule 2 (Form 1040), line 8.
If you qualify for an exception but the code says otherwise, you have to file the form. The IRS states that when a distribution meets an exception, but box 7 on Form 1099-R doesn’t show an exception, use Form 5329. For our 54-year-old, Part I of the form works like this:
- Line 1: early distributions included in income, $40,000.
- Line 2: the exempt amount, $27,500, plus the medical-expense exception number from the form instructions.
- Line 3: the amount still subject to the penalty, $12,500.
- Line 4: the additional tax, $1,250, which carries over to Schedule 2.
You don’t need Fidelity to issue a corrected form. You do need records, such as bills and insurance company statements, in case the IRS asks. The rule works both ways: a code 2 won’t protect you if you don’t actually qualify. The statute determines what you owe, and the code is just the custodian’s best guess.
Exceptions Custodians Often Can’t See
Publication 17 lists exceptions for IRA owners that custodians usually have no way to verify:
- Medical expenses above 7.5% of your AGI
- Health insurance premiums paid during unemployment
- Total and permanent disability
- A certified terminal illness
- Inheriting the IRA from a deceased owner
Workplace plans have one more exception. Under § 72(t)(2)(A)(v), withdrawals made to an employee after separation from service after attainment of age 55 escape the penalty. Form 5329 lists it as exception 01. It applies only to employer plans such as 401(k)s and never to IRAs.
Three Moves That Keep Code 1 From Costing You
- Check Box 7 before you file. Tax software reads the code automatically. If it says 1 and you qualify for an exception, open Form 5329 yourself.
- Take early withdrawals from the 401(k) before you roll it over. If you left your job at 55 or later, moving the money to an IRA first gives up the separation-from-service exception for good.
- Pay medical bills and take the withdrawal in the same year. The medical exception is measured against that year’s expenses and that year’s AGI.
A common mistake is treating Box 7 as a final ruling. Code 1 only tells the IRS what your custodian knew. If you qualify for an exception it didn’t know about, Form 5329 is how you claim it, and the savings can run into thousands of dollars. (This is one of nine IRS rules that quietly cost savers money, all mapped in our free Retiree’s Tax Trap Map.)
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Vilma Rios is a tax professional and tax content contributor with more than 15 years of experience in tax and accounting. She specializes in federal tax research, tax education, and translating complex tax rules into clear, practical information for individuals, families, and small-business owners.
Vilma is a Content Tax Contributor II with the National Association of Tax Professionals (NATP), where she contributes to tax education and professional content. She has also presented tax information through webinars, including Spanish-language tax education, and has appeared on Telemundo 47 discussing tax topics and helping viewers understand important tax-filing requirements.
Her experience also includes tax and accounting work, tax research, IRS-related matters, and public tax education. While in college, Vilma volunteered in an IRS-sponsored tax assistance program and was recognized for her community service by local and state officials.
Known as “Your Tax Geek,” Vilma is passionate about making taxes easier to understand and helping people navigate an increasingly complex tax system.
