1099-R Box 7 Code 2: Exceptions, Reporting, and Withholding

Code 2 in Box 7 of Form 1099-R means the payer classified your withdrawal as an early distribution (taken before age 59½) but one that qualifies for a recognized exception to the 10% additional tax under Section 72(t). The money is still taxable as ordinary income, but no penalty applies, and in most cases you won’t need to file Form 5329 to prove it.¹

How Code 2 Differs From Code 1

Box 7 carries a one- or two-character code that tells the IRS what kind of distribution you received, and the code controls whether a penalty is expected.² Code 2 reads as “Early distribution, exception applies.” Code 1 reads as “Early distribution, no known exception.”

The practical difference is who does the paperwork. With Code 2, the plan administrator has already told the IRS a statutory exception covers the withdrawal, so the penalty simply doesn’t show up. With Code 1, the IRS assumes the 10% penalty is owed, and if you actually qualify for an exception, you have to file Form 5329 yourself and claim it.³

So if you’re seeing Code 2, the payer has done the work for you. What matters next is confirming the exception they had in mind actually fits your situation.

Situations That Produce Code 2

Payers use Code 2 only for exceptions they can verify at the time of distribution. That’s a smaller list than the full set of penalty exceptions in the tax code.

Separation From Service in or After the Year You Turn 55

If you leave your job in or after the calendar year you reach age 55, distributions from that employer’s qualified plan are penalty-free.⁴ The trigger is the calendar year, not the birthday. This is one of the most common reasons Code 2 appears on a 1099-R. It applies to 401(k)s, pensions, and similar employer-sponsored plans. It does not apply to IRAs.¹

Public Safety Employees and Firefighters After Age 50

Qualified public safety employees who separate from a governmental plan can take penalty-free distributions starting at age 50, or after 25 years of service under the plan, whichever comes first. The same rule reaches firefighters in qualified plans, 403(a) plans, and 403(b) plans. SECURE 2.0 expanded this lower age threshold.¹

Substantially Equal Periodic Payments

You can avoid the penalty by setting up a series of substantially equal periodic payments, often called 72(t) payments or SEPPs, calculated using one of three IRS-approved methods.⁵ The schedule has to continue for at least five years or until you reach age 59½, whichever is longer. Modify it early, for any reason other than death or disability, and the IRS applies the 10% penalty retroactively to every payment you took under the arrangement, plus interest from the year of each distribution.⁴ Changes to the payment amount, an extra withdrawal from the same account, or a mid-stream rollover are the usual ways people break a SEPP.

Total and Permanent Disability

Distributions are penalty-free if you’re unable to engage in any substantial gainful activity because of a physical or mental condition expected to result in death or last indefinitely.⁶ The standard is strict. Keep your physician’s certification indefinitely; the IRS can ask for proof.

Qualified Domestic Relations Orders

When a court issues a QDRO in a divorce directing part of a participant’s retirement plan to a spouse, former spouse, or dependent, payments to that alternate payee are penalty-free.⁶ The alternate payee can also roll the money into their own IRA to defer taxes. This exception applies to employer-sponsored plans, not IRAs.

Roth Conversions

When you convert a traditional IRA to a Roth IRA before age 59½, the payer reports the distribution with Code 2. The converted amount is taxable that year, but no penalty applies to the conversion itself.¹ Note that separate penalty rules can apply if you later withdraw the converted funds from the Roth within five years.

Other Code 2 Situations

IRS levy on the retirement account to collect a tax debt.
Distributions from governmental 457(b) plans (generally not subject to the 10% penalty).
Withdrawals under an eligible automatic contribution arrangement, taken within 90 days of auto-enrollment.

Penalty Exceptions That Don’t Produce Code 2

This is where readers get confused, so it’s worth being explicit. Several well-known penalty exceptions exist, but the payer reports the distribution with Code 1 because they can’t verify the exception at the time you take the money. You claim the exception yourself on Form 5329:¹

Unreimbursed medical expenses above 7.5% of adjusted gross income.
Health insurance premiums while unemployed (IRA distributions).
Higher education expenses (IRA distributions, not 401(k)s).
First-time home purchase, up to a $10,000 lifetime limit from an IRA.⁷
Qualified birth or adoption, up to $5,000 per event within one year.
Terminal illness, with a physician’s certification that death is expected within 84 months.
Emergency personal expenses, up to $1,000 per year under a SECURE 2.0 provision effective after 2023.⁸
Domestic abuse victim distributions under SECURE 2.0.
Qualified reservist distributions for reservists called to active duty for at least 180 days.

Seeing Code 1 when you expected a penalty-free distribution doesn’t mean the payer got it wrong. It usually means the exception is one you claim yourself.

Reporting a Code 2 Distribution on Your Return

The distribution is taxable income even though the penalty is waived. Use the amounts from your 1099-R on Form 1040: Box 1 (gross distribution) goes on Line 4a for IRA distributions or Line 5a for pension and annuity distributions, and Box 2a (taxable amount) goes on Line 4b or 5b.⁹

You Usually Don’t Need Form 5329

The Form 5329 instructions say directly that you don’t need to file it if the code in Box 7 already indicates the exception and you aren’t subject to the additional tax.¹⁰ Code 2 is one of those codes. The payer already told the IRS an exception applies.

You would need Form 5329 in two situations: the exception covers only part of the distribution (some of it is still penalty-eligible), or the Box 7 code is wrong and you want to override it. In those cases, enter the total early distribution on Line 1 and the exempt amount on Line 2 with the applicable exception number. Any remainder flows to Schedule 2.¹⁰ Common exception numbers that map to Code 2 situations include 01 (separation from service after 55, or 50 for public safety), 02 (SEPP), 03 (disability), and 06 (QDRO alternate payee). If more than one exception applies to different portions of the same distribution, enter 99.

Withholding Still Applies

Code 2 removes the penalty, not the withholding. If your distribution from an employer plan like a 401(k) is an eligible rollover distribution and you take it as cash instead of rolling it directly to another retirement account, the plan must withhold 20% for federal income tax. You can’t opt out. The only way to avoid it is a direct rollover to an eligible plan.¹¹

For distributions that aren’t eligible rollovers, such as SEPP payments, withholding defaults to 10% and you can adjust it or opt out. Box 4 on the 1099-R shows what was actually withheld, and you claim that as tax paid.

Fixing an Incorrect Code

If your 1099-R shows Code 1 when it should show Code 2, or the other way around, contact the plan administrator or financial institution that issued the form and ask for a corrected 1099-R.¹² Most payers will fix the code once you provide documentation.

If the payer won’t cooperate, you can call the IRS at 800-829-1040 or file Form 4852 as a substitute for the incorrect 1099-R, with an explanation attached to your return. Filing Form 4852 can delay processing because the IRS has to reconcile with the payer’s original filing.¹³

There’s also a simpler route when the issue is Code 1 on a distribution that genuinely qualifies for an exception: file Form 5329 with the correct exception number and skip the fight with the payer. The IRS will accept the form as your documentation.³ Keep whatever supports the exception: separation paperwork with your age and last day, a SEPP calculation, medical records, or a copy of the QDRO.

1
Internal Revenue Service. Instructions for Forms 1099-R and 5498
2
Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025)
3
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
4
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
5
Internal Revenue Service. Substantially Equal Periodic Payments
6
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
7
Internal Revenue Service. Topic No. 557, Additional Tax on Early Distributions From Traditional and Roth IRAs
8
Internal Revenue Service. Certain Exceptions to the 10 Percent Additional Tax Under Code Section 72(t)
9
Internal Revenue Service. 1040 (2025)
10
Internal Revenue Service. 2025 Instructions for Form 5329 – Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts
11
eCFR. 26 CFR 31.3405(c)-1 Withholding on Eligible Rollover Distributions; Questions and Answers
12
Internal Revenue Service. What to Do When a W-2 or Form 1099 Is Missing or Incorrect
13
Internal Revenue Service. About Form 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R