If you take an early withdrawal from an IRA, you may be assessed a tax penalty, unless a special exception applies. But the courts aren’t always lenient on this rule.
For example, in a new case, Gillette TC Memo 2018-195, 11/20/18, the Tax Court wouldn’t approve a taxpayer’s prescription-treated gambling addiction as a “disability” under a tax law exception.
Let’s start with this basic premise: When you withdraw funds from a traditional IRA, you must pay tax on the portion of the distribution representing deductible contributions and earnings. Also, if you’re under age 59½, you must add on a 10 percent penalty tax. This applies to the taxable portion of the payout.
However, you can avoid this 10 percent penalty if you qualify for one of several exceptions listed in Section 72(t) of the tax code. These include:
- Distributions made to your beneficiary or estate on or after your death;
- Distributions due to disability;
- Distributions made as part of a series of substantially equal periodic payments (SEPPs);
- Distributions for medical expenses exceeding 7.5 percent of your adjusted gross income (AGI);
- Distributions made to pay for qualified higher education expenses; or
- Distributions made for first-time homebuyers (p to a lifetime limit of $10,00).
In the new case, the taxpayer had previously served in the military and worked as a firefighter. She also purchased and managed rental properties. Her husband was a police officer.
In the early 2000s, she began taking prescription medication for restless legs syndrome. Over time, the medication became less effective, and the taxpayer’s doctor increased her dosage. After one such increase in 2010, she began exhibiting severe compulsive behavior, most notably compulsive gambling.
From this point on, the taxpayer’s gambling activity spiraled out of control. She began traveling hours from her home to play live casino games, increasing her bets to up to $500 on a single play at a slot machine and betting thousands of dollars on a single hand of blackjack. She opened credit lines at various casinos, and many were soon in default.
On one occasion, the taxpayer won about $162,000. She left the casino with less, having played and lost a portion of her winnings. She went immediately to another casino that had closed one of her many credit lines and paid off her debt so they would extend her further credit. Days later, without much sleep and without leaving the casino, the taxpayer gambled away all of her winnings.
Frequently, she would go days without sleeping or slept in her car if she wasn’t given a complimentary night’s stay at a casino. Other times, she would fall asleep at blackjack tables and slot machines, only to be awakened by dealers and attendants.
Almost all the money she collected from her rental properties went to casinos. When she ran short, she borrowed from friends and didn’t pay them back, took money and credit cards from her husband’s wallet and eventually withdrew money from her IRA in 2012.
On their 2012 return, the couple claimed the taxpayer wasn’t responsible for the 10 percent penalty tax on early IRA withdrawals because of her disability.
The Tax Court noted that a taxpayer is disabled if he or she is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” However, an impairment that is remediable does not constitute a disability for this purpose.
Based on the facts of the case, the Tax Court determined that the taxpayer’s impairment does not prevent her from engaging in substantial gainful activity. Therefore, she didn’t qualify for the exception from the penalty.
Moral of the story: Advise your clients about the pitfalls of early IRA withdrawals. Make sure they are on firm ground if they will be relying on a 72(t) exception.