Generally, distributions from qualified retirement plans like 401(k) plans and IRAs are subject to a 10 percent penalty for early withdrawals, but certain exceptions may apply. The IRS usually sticks to the strict letter of the law on these exceptions, but not in a recent Tax Court case.
In McCreeTC Memo 2019-67, 6/6/19, a “kinder, gentler” IRS decided to cut one taxpayer some slack. The basic rule is that distributions from qualified retirement plans and IRAs are fully taxable plus the 10 percent penalty applies to the taxable part of withdrawals made before age 59½. The list of exceptions is a lengthy one for distributions from both qualified plans and IRAs.
Although many of the exceptions mirror themselves, some differences do exist. For example, payouts made on account of disability are exempted for both qualified plans and IRAs.
Yet, payouts at age 55 or older when you separate from service is an exception for qualified plan distributions, but not IRAs. Conversely, exceptions for qualified education expenses and first-time homebuyer expenses only apply to IRAs—not qualified plans.
In the new Tax Court case, the taxpayer, a resident of Texas, terminated her employment with the Department of Family and Protective Services in 2010 to become a full-time student at the University of Phoenix. In November of that same year, she requested a withdrawal from a retirement account she had with the Employees Retirement System of Texas (ERS). The taxpayer’s ERS retirement plan was a qualified defined benefit plan.
The taxpayer received a distribution of approximately $20,0000 from her ERS account. After federal income tax of about $4,000 was withheld from her ERS distribution, she received a check for close to $16,000, which she deposited in her savings account at Bank of America. The taxpayer was 42 years old when she received this distribution. She used the proceeds from her ERS distribution to cover some of her tuition and living expenses.
The taxpayer claimed that the distribution from her qualified plan qualified for the exception for education expenses. The problem: Technically, this exception only applies to IRAs and not qualified plans.
Nevertheless, the IRS conceded the issue at trial, despite the clear language of the law. Of course, the $20,000 distribution is still subject to regular income tax.
Don’t assume that the IRS will give your clients a break. Make sure they are fully informed about the rules for qualified plan and IRA distributions and take all the relevant tax consequences into account.