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Tax Court Waives Early Withdrawal Penalty in Convoluted New Case

Generally, taxpayers are cautioned against making early withdrawals from their retirement accounts, due to the hefty penalties associated with doing so. However, one individual whose case went before Tax Court did just this and argued she shouldn't be charged a fee, with mixed results.

Sep 1st 2020
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If you make an “early withdrawal” from a traditional IRA, you generally are hit with a 10 percent tax penalty, on top of the regular income tax you owe. But the tax code contains a number of special exceptions. In a new case, Seril, TC Memo 2021-101, 7/8/20, a taxpayer claimed that her early withdrawal qualified for the exception for education expenses, with mixed results.

Background: Typically, you are subject to the 10 percent tax penalty if you withdraw funds from a traditional IRA before you have attained age 59½. However, you may qualify for one of several exceptions listed in the tax code. (A comparable list of exceptions applies to early withdrawals from qualified retirement plans.)

The list of exceptions to the 10 percent penalty tax for early distributions from IRA includes distributions that are:

  • Made to a beneficiary or estate on account of the IRA owner's death;
  • Made on account of disability;
  • Made as part of a series of substantially equal periodic payments for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and a designated beneficiary;
  • Qualified first-time homebuyer distributions;
  • Not in excess of your qualified higher education expenses;
  • Not in excess of certain medical insurance premiums paid while unemployed;
  • Not in excess of your unreimbursed medical expenses above the stated percentage of AGI;
  • Due to an IRS levy; and
  • A qualified reservist distribution.

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, another exception has been added for early withdrawals. The CARES Act exception is available for payouts in 2020 of up to $100,000 for an individual (or his or her spouse) who is diagnosed with COVID-19 or has experienced adverse financial consequences as a result of being laid off, having work hours reduced or being quarantined or furloughed due to COVID-19.

In the new case, a taxpayer residing in New York was in the middle of a distressing divorce, involving claims of domestic violence and child neglect. Her son was expected to attend Morehouse College in the fall. To help pay for his tuition and living expenses, she made two withdrawals from her traditional IRA totaling $54,500. The taxpayer was not age 59½ at the time.

The IRS assessed tax deficiencies relating to the IRA distributions, the 10 percent penalty tax on early withdrawals and an accuracy-related penalty.

The taxpayer claimed that she didn’t owe the tax on $15,000 of the distributions she had intended to roll over into an IRA but didn’t follow though due to her personal circumstances. She also argued that the distributions were exempt from the 10 percent penalty tax because she qualified for the exception for higher education expenses.

Tax outcome: The Tax Court granted the taxpayer a partial victory. She was able to show that approximately $30,000 was paid directly to Morehouse College, so the penalty for early IRA withdrawals doesn’t apply to that amount. But she is still liable for the regular tax on the distributions and the penalty tax on the remainder.

Finally, the Court waived the accuracy-related penalty due to the personal issues the taxpayer was experiencing at the time.

Moral of the story: Make sure your clients can account for amounts that may qualify for an exception to the 10 percent penalty tax. Document all transactions and maintain accurate records.

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