Let’s talk a
bit about hardship distributions from your retirement plan – perhaps your
401(k).
You may know
that you are not supposed to touch this money before a certain age. If you do,
not only will there be income taxes to pay, but also a 10% early withdrawal penalty.
These are two moving pieces here: one is the income tax on the distribution and
another for the 10% penalty.
Here is a
question for you:
Let’s say you can withdraw money from your plan for hardship reasons. Does that mean that the penalty does not apply?
The answer
is no. One would think that the two Code sections move in tandem, but they do
not.
Candace
Elaine ran into this in a recent Tax Court decision.
Candace
lived in California, and in 2012 she withdrew $84,000 from her retirement plan.
She had lost her job in 2009, and she was trying to support herself and family.
The tax Code
applies two requirements to the income taxation of hardship withdrawals:
·
On
account of an immediate and heavy financial need, and
·
Any
amount withdrawn is limited to actual need
An
“immediate and heavy financial need” would include monies needed for medical
expenses or to avoid foreclosure. In addition, one is not allowed to withdraw
$20,000 if the need is only $12,000, with the intention of using the excess for
other purposes.
The plan
custodian is the watchman for these two requirements. The custodian is to
obtain reasonable assurance of need and inquire whether other financial
resources exist. This is a role above and beyond routine administration, and
consequently many plans simply do not offer hardship withdrawals.
Candace met
those requirements and her plan allowed withdrawals. She reported and paid
income tax on the $84,000, but she did not pay the 10% penalty.
The IRS
bounced her return. Off to Tax Court they went, where Candace represented
herself.
Her argument
was simple: I received a hardship distribution. There is an exemption for
hardship.
The IRS said
that there was not. And in the spirit of unemployed taxpayers trying to support
their family, the IRS assessed a penalty on top of the 10% chop.
The Court
pointed several exceptions to the 10% early withdrawal penalty, including:
·
Separation
from service
·
Disability
·
Deductible
medical expenses
·
Health
insurance premiums while unemployed
·
Higher
education
·
First
time purchase of a principal residence
There isn’t
one for hardship, though.
Meaning that
Candace owed the 10% penalty.
The Court
did note that the misunderstanding on the 10% is widespread and refused to
assess the IRS’ second penalty.
Why did
Candace not just borrow the money from her 401(k) and avoid the issue? Because
she had been let go, and you have to be employed in order to take a plan loan.
What if she
had rolled the money into an IRA?
IRAs are not
allowed to make loans, even to you. The only way you can get money out of an
IRA is to take a distribution. This is what sets up the ROBs (Roll-Over as
Business Start-Up) as a tax issue, for example.
Candace was
stuck with the penalty.
