By Jeremy T. Rodriguez, JD
Every so often, the IRS or the courts remind us that the exceptions to the 10% early distribution penalty are narrowly interpreted. That means if your situation doesn’t fit the letter of the law to a “t,” then the exception will not apply, and the tax will be due.
Such was the case for Mr. and Mrs. Thompson, a married couple struggling with outstanding tax liabilities. The Thompsons’ owed back taxes for the 2002, 2003, and 2004 calendar years. To make matters even worse, they received a Final Notice from the IRS which indicated that it was looking to levy on their property. Faced with this situation, the Thompsons’ withdrew over a million dollars from their retirement plan to settle the tax debt. While they were able to resolve that situation with the IRS, the $1 million-dollar retirement plan withdrawal created another problem: both were under age 59 ½ when the distribution was made. That triggered the 10% early distribution penalty.
The Thompsons paid the penalty, which in this case amounted to $122,784. However, they sued the IRS in district court seeking a refund of the payment. One of the exceptions to the 10% penalty is for distributions made under an IRS levy. The Thompsons argued that because the retirement plan distribution was (A) used to settle an outstanding tax bill, and (B) occurred after the IRS issued a Final Notice and Intention to Levy, the exception applied and they were not liable for the penalty.
Unfortunately for the Thompsons, the Court disagreed and upheld the penalty. Previous cases, and the Tax Code itself, make it clear that the exception does not apply unless the retirement account itself is levied, and the distribution is triggered by the IRS. In the end, not only did they lose over a $1 million dollars in retirement assets to satisfy an old tax debt, but the additional $122,784 early withdrawal penalty was upheld.
In addition to the exception for distributions made pursuant to an IRS levy, the Tax Code also exempts the following distributions from the 10% early withdrawal penalty:
- Distributions made after age 59 ½
- Distributions to a beneficiary due to death
- Distributions after an employee is disabled
- Distributions that are a part of a series of substantial periodic payments
- Distributions made from an employer plan to an employee after a separation of service that occurs when the individual is age 55 or older
- Certain corporate dividends
- Distributions made pursuant to an IRS levy
- Distributions from an employer plan made under a Qualified Domestic Relations Order
- Distributions used for qualified medical expenses
- Distributions from an IRA used for higher education expenses
- Distributions from an IRA that are used to purchase a primary residence
- Distributions from an IRA to unemployed individuals that are used to buy health insurance
- Distributions to individuals that are called to active duty in the armed forces
As we saw in the Thompson case, each of these exemptions has several requirements that must be considered. Some only apply to IRAs, others to qualified retirement plans, and some apply to both. Each of the exemptions will also have their own limitations and special rules that will determine whether a taxpayer qualifies for preferential treatment. Lastly, the exemptions are interpreted narrowly by both the IRS and the courts.
For example, the Thompson case teaches us that not only must an IRS levy be on file, but the levy must be directed at the IRA or retirement plan and the IRS must trigger the distribution; not the other way around. Another good example of the distinctions between these exemptions was the case of Young Kim. Here the taxpayer terminated service with his employer after he reached age 55, rolled over his employer plan assets to an IRA, and began taking distributions from that IRA. The exception to the 10% penalty for employees that separate service at age 55 or older only applies to a company plan, not IRAs. As a result, Mr. Kim was hit with a massive penalty that he could have easily avoided.
In the end, if you are thinking about taking a distribution from an IRA or company retirement plan and believe your situation qualifies for one of the exemptions mentioned above, stop and take a step back. Unless the situation is clear cut, or you have a firm understanding of the tax rules, it is probably best to consult with a knowledgeable advisor. Failing to do so could cause you to incur an unnecessary, and in many cases substantial, IRS penalty.