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Finding a Cure for Early Withdrawal Tax Penalties

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As we know, qualified retirement plans and IRAs are meant to be used for retirement savings. However, if your client is forced to tap into a plan or traditional IRA early for a legitimate reason like a medical emergency, they may be able to avoid the usual penalty tax for early withdrawals, but take caution.

Apr 18th 2022
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As shown by a new Tax Court case, Salter, TC Memo 2022-29, 4/5/22, the exception for an early withdrawl of retirement funds for medical expenses is a narrow one.

Normally, distributions from a qualified plan or IRA are taxable at ordinary income rates, currently reaching as high of 37 percent. In addition, the IRS tacks on a 10 percent tax penalty if you make a withdrawal prior to age 59½. The penalty tax applies to the taxable portion of the distribution.  For example, if your client is an age-50 taxpayer in the top tax bracket and you withdraw $10,000 that is fully taxable, you owe a total tax of $3,370 on the distribution ($3,700 + $370).

However, the tax code includes numerous exceptions to the 10 percent penalty tax for pre-age 59½ withdrawals from qualified plans and traditional IRAs. One such exception covers distributions used to pay for qualified medical expenses—including hospital and physician visits— but the tax break only applies to unreimbursed expenses above the annual medical deduction threshold.

For 2022, the threshold is 7.5 percent of adjusted gross income (AGI), down from the previous mark of 10 percent of AGI. The change to 7.5 percent of AGI is permanent.

Facts of the new case: The taxpayer, a resident of Arizona, was laid off midway through 2013. To tide himself over during his period of unemployment, he received a distribution of $37,647 from his retirement plan. He had not yet reached the age of 59½ at that time. Although the taxpayer testified before the Tax Court that he had consulted doctors during 2013 and paid medical insurance premiums after he lost his job, he didn’t submit documentary evidence of any kind to support that assertion.

In any event, the exception from the 10 percent penalty tax for early withdrawals from a qualified plan or IRA only applies to amounts that would have been deductible as medical expenses in excess of the annual threshold. For the tax year in question—2013—the threshold was 10% of AGI. Even if the taxpayer had substantiated his alleged medical expenses, he would not have cleared the 10%-of-AGI mark. Accordingly, the Tax Court determined that the taxpayer owes the 10 percent penalty tax on the full amount of his retirement plan distribution.

Footnote: The exception for medical expenses is available whether or not you itemize deductions on your tax return. Even if your client takes the standard deduction, however, you must do the calculation based on 7.5 percent of AGI.  

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