Exceptions to Early Distribution Penalties

 

What caught my eye about the case was the reference to an “oral opinion.”

Something new, methought.

Better known as a “bench opinion.’

Nothing new, methinks.

What happened is that the Tax Court judge rendered his/her opinion orally at the close of the trial.

Consider that a tax case will almost certainly include Code section and case citations, and I find the feat impressive.

Let’s talk about the case, though, as there is a tax gotcha worth discussing.

Molly Wold is a licensed attorney. She was laid-off in 2017. Upon separation, she pulled approximately $86 grand from her 401(k) for the following reasons:

(1)  Pay back a 401(k) loan

(2)  Medical expenses

(3)  Student loans

(4)  Mortgage and other household expenses

You probably know that pulling money from a 401(k) is a taxable event (set aside a Roth 401(k), or we are going to drive ourselves nuts with the “except-fors”).

Alright, she will have income tax.

Here is the question: will she have an early distribution penalty?

This is the 10% penalty for taking money out from a retirement account, whether a company plan (401(k), 403(b), etc) or IRA and IRA-based plans (SIMPLE, SEP, etc). Following are some exceptions to the penalty:

·      Total and permanent disability

·      Death of the account owner

·      Payments over life expectancy; these are sometimes referred to as “Section 72(t)” payments.

·      Unreimbursed medical expenses (up to a point)

·      IRS levy

·      Reservist on active duty

Then it gets messy, as some exceptions apply only to company-based plans:

·      Leaving your job on reaching age 55 (age 50 if a public safety employee)

Is there a similar rule for an IRA?

·      Withdrawals after attaining age 59 ½.

Why age 55 for a 401(k) but 59 ½ for an IRA?

Who knows.

Molly was, by the way, younger than age 55.

There are exceptions that apply only to a company-based plan:

·      A qualified domestic relations order (that is, a divorce)

·      Dividends from an ESOP

There are exceptions that apply only to an IRA and IRA-based plans:

·      Higher education expenses

·      First-time homebuyer (with a maximum of $10,000)

Yes, Congress should align the rules for both company, IRA and IRA-based plans, as this is a disaster waiting to happen.

However, there is one category that all of them exclude.

Ms Wold might have gotten some pop out of the exception for medical expenses, but that exclusion is lame. The excluded amount is one’s medical expenses exceeding 7.5% of adjusted gross income (AGI). I suppose it might amount to something if you are hit by the proverbial bus.

The rest of the $86 grand would have been for general hardship.

Someone falls on hard times. They turn to their retirement account to help them out. They take a distribution. The plan issues a 1099-R at year-end. Said someone says to himself/herself: “surely, there is an exception.”

Nope.

There is no exception for general hardship.

10% penalty.

Let’s go next to the bayonet-the-dead substantial underpayment penalty. This penalty kicks-in when the additional tax is the greater of $5,000 or 10% of the tax that should have been shown on the return.

Folks, considering the years that penalty has been around, you would think Congress could cut us some slack and at least increase the $5 grand to $10 grand, or whatever the inflation-adjusted equivalent would be.

Ms Wold requested abatement of the penalty for reasonable cause.

Reasonable cause would be that this area of the Code is a mess.

You know who doesn’t get reasonable cause?

An attorney.

Here is the Court:

So I will hold her as a lawyer and as a highly intelligent person with a good education to what IRS instructions that year showed.”

Our case this time was Woll v Commissioner, TC Oral Order.