My IRA plan is designed as an annuity to be paid out in limited amounts annually. We have taken distributions early and are charged a penalty by the IRA firm, but the form we received at the end of the year just shows the distribution and not the penalty they charged.
First, verify that the penalty fee came out of the funds that were distributed to you, rather than the funds that remained in the IRA account.
If the fee was paid from the distribution and included in box 1 of the 1099-R, it is deductible. However, it is only deductible as an investment expense. Investment expenses are subject to being a misc. itemized deduction subject to the 2% of AGI threshold. You do not get to reduce the reportable amount of the distribution by the amount of the fee.
If the fee was paid from funds, still in the IRA, it is not deductible.
Reference: http://finance.zacks.com/surrender-charges-qualified-annuity-taxdeductible-10914.html
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