What is a Penalty Tax?

A penalty tax is a form of punitive tax designed to create a disincentive for certain types of behavior. This tax can be assessed at the local, state, or national level, depending on the tax code and the behavior under discussion. One example of a penalty tax is an early withdrawal penalty on retirement accounts. People who choose to access their retirement accounts before they mature will be taxed on the proceeds.

These taxes serve a number of functions. First, they discourage people from doing things the government considers potentially harmful, as well as activities that are specifically illegal. In this sense, the penalty tax is the cost of making a decision barred or discouraged by law. Such taxes also directly punish people for activities like not paying their taxes. In addition, they raise income for the government, providing more tax revenues.

People may pay a penalty tax for accessing financial accounts set aside for specific purposes, not paying their taxes or paying taxes late, and for receiving certain types of gifts and benefits. Critics of penalty taxes argue that often they pertain to lawful activities and thus are a disincentive for behavior people are allowed to engage in; for example, if people receive certain benefits through work, this could be considered a private matter between employer and employee, not a subject of taxation. Likewise, people accessing retirement accounts usually do so with good reason, and a punitive tax can expose them to additional financial harm.

Advocates for the penalty tax believe it creates an incentive for social and fiscal responsibility. People considering activities that may expose them to a penalty tax could think twice about them. In cases where it is a punitive measure for breaking the law, such as a tax charged on late or unpaid taxes, it creates an internal enforcement mechanism for tax agencies. Instead of having to seek legal penalties, the agency can simply collect a penalty tax, thus receiving compensation for the illegal activity, as well as punishing the wrongdoer.

If an activity is subject to a penalty tax, people should be provided with information about the nature of the tax and how to declare the activity on their tax forms. People concerned about paying taxes for things like gifts, bequests, and benefits can discuss them with a tax attorney or accountant to see if there is a way to avoid the penalty, such as taking a gift in installments to avoid running afoul of annual limits.