The 10% Penalty Exceptions for Education and First Time Home Buyer Apply Only to Distributions From IRAs – NOT to Plans

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  • The 10% Penalty Exceptions for Education and First Time Home Buyer Apply Only to Distributions From IRAs – NOT to Plans

10% Early Withdrawal Penalty Exceptions and Traps

Early withdrawals from retirement accounts should be discouraged because it reverses the retirement savings process and early distributions are the most expensive. They are highly inefficient as they are subject to both income tax and the 10% early withdrawal penalty, which combined, can erode half of the distribution. It would be better to take the necessary cash from a non- taxable account, if available. If not, even a home equity loan would be better. The loan proceeds received would be tax free and the interest on the home equity loan may be tax deductible.
But in the real world, people do need to access their retirement funds early. The income tax cannot be avoided on early distributions, but the 10% early withdrawal penalty sometimes can be avoided. Advisors should do all they can to help clients at least avoid the penalty by making sure the distribution qualifies for one of the many exceptions available.

Three Categories of Early Withdrawal Exceptions

Not all exceptions apply to all plans. Many of the people who pay the 10% penalty pay it because the exception they used did not apply to their distribution. For example, the age 55 separation from service exception only applies to distributions from company plans and not from IRAs.
  • Exceptions that apply to distributions from both company plans and IRAs
  • Exceptions that apply only to distributions from IRAs
  • Exceptions that apply only to distributions from company plans
Not knowing which exception applies to which plan can get a client (and their advisor) into trouble.
There are numerous tax court cases where the taxpayers lost and had to pay the 10% early withdrawal penalty because the exception they claimed did not apply to the plan where they took the distribution from. The biggest errors here are the exceptions for first time homebuyer and higher education. These exceptions apply only to distributions from IRAs and never from company plans. Yet, taxpayers keep going to court to fight this and lose every time.

A school teacher withdrew $67,553 from her 403(b) plan. She used the money to pay for college education expenses. She paid the income tax but not the 10% penalty because she believed that the exception for higher education applied to distributions from company plans. It does not, as she found out when she lost in court. The 10% penalty for higher education expenses only applies to distributions from IRAs and never to distributions from plans. (Christine L. Gibbons v. Commissioner; T.C. Summ. Op. 2006- 106; No. 5464-05S; July 13, 2006)

Keith Lamar Jones, an accountant at Deloitte & Touche left the firm to begin full time studies in a Ph.D. program. He received a distribution of $30,369 from his 401(k) and used those funds to pay his education expenses and to purchase his first home. Keith believed he was exempt from the 10% penalty since the funds were used both for higher education and a first time home purchase. He claimed that he could have transferred the 401(k) funds to an IRA if he wanted to and his argument was that the difference between a 401(k) and an IRA is a “matter of form.” He lost his case because there is a difference and the difference is that these exceptions only apply to distributions from IRAs and NOT from plans. (Keith Lamar Jones v. Commissioner:T.C. Summ. Op. 2005-173; No. 6936-04S; November 29, 2005)

September 30, 2003
Budding lawyer blows his first case…his own!
He withdraws from wrong account and triggers a 10% early withdrawal penalty

John McGovern, et ux. V. Commissioner; T.C. Summary Opinion 2003-137; No. 19183- 02S John McGovern was a full time student at Villanova University School of Law. During 1999 he received a lump-sum distribution of $27,880 from his Federal Employees’ Thrift Savings Plan (TSP) and deposited that into a personal checking account. He rolled $15,000 of that into an IRA and used the remaining $12,880 to pay tuition and education fees to Villanova University in 1999. He was under 59½ years old in 1999. On the tax return McGovern filed for 1999, he reported the $12,880 as taxable income but did not pay the 10% early withdrawal penalty on the $12,880 not rolled over and used for education. IRS said that a 10% penalty of $1,288 was owed on the $12,880 early withdrawal. McGovern decided to go to tax court representing himself to prove that the IRA exception applied in this case, even though the distribution clearly came from his TSP, a qualified retirement plan. He had a two-prong defense. First, McGovern contended that the 10% early withdrawal penalty did not apply based on Larotonda v. Commissioner [89 T.C. 287 (1987)] but the court rejected that argument. In the Larotonda case, the Court said that the 10% penalty did not apply to a distribution from a plan, but in that case the IRS levied against a Keogh account for payment of back taxes and the bank paid the funds directly to the IRS. The taxpayer never took possession of those funds and thus had no opportunity to avoid the 10% penalty. The Court ruled that the 10% penalty did not apply in that case under former Section 72(m)(5). After that argument failed, McGovern decided to use “the doctrine of substance over form” which sounds like he just learned that in law school. His reasoning was that the withdrawal from the TSP should be treated as if he first rolled those funds to an IRA and then withdrew them from the IRA to pay the education expenses. If he in fact had done that, the distribution would have qualified for the exception to the 10% penalty since the withdrawal would have actually been from the IRA and not the TSP. The Court rules against McGovern on this argument as well, stating that “The substance over form doctrine” did not apply. The Court said that “the Supreme Court has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.” Commissioner v. Natl. Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (citations omitted). Similarly, the United States Court of Appeals for the Third Circuit has also observed: “The government has the right to claim that the form of a transaction should not be utilized to postpone taxes that are otherwise due. The taxpayer does not have the like right to contend that the form that it has chosen should be ignored so that avoidance or postponement of the tax can be accomplished.” Strick Corp. v. United States, 714 F.2d 1194, 1206 (3d Cir. 1983). The Court ruled that McGovern is liable for the 10% penalty on the $12,880 distribution from the TSP that McGovern used to pay tuition and fees to Villanova University. The Court made it clear that the $12,880 distribution was not a distribution from an IRA and cannot be construed as one and the 10% penalty exception does not apply in this case.

Hardship Withdrawals

No Exception from the 10% Penalty Exists for Hardship Distributions

Regardless of your financial situation, there is no such thing as a hardship
withdrawal from an IRA. If you have to tap your IRA before reaching age 59½, a financial hardship will not relieve you of the 10% penalty.

In a recent case, Andrew Gallagher found that out the hard way. His pay was cut and he withdrew $6,000 from his IRA to help pay bills. He felt he was exempt from the 10% penalty by claiming “financial hardship.” The Tax Court ruled that there is no such exemption and none of the other exemptions applied to him (Gallagher, T.C. Memo2001-34).

There is a financial hardship provision in many 401(k) plans, but that only permits participants to withdraw earlier than the plan would otherwise allow. The withdrawal is still taxable and subject to the 10% penalty.

“Economic hardship” is NOT an acceptable exception to the
10% early withdrawal penalty. But taxpayer’s ignorance got her out of the 20% accuracy related penalty

Meleca Vulic v. Commissioner; T.C. Memo. 2004-51;
(United States Tax Court No. 14859-02); March 8, 2004

In 2000 Meleca Vulic received a lump-sum distribution of $81,169 from her company retirement plan. She was under 59½ years old. She used this money to refinance her house, pay for her son’s wedding, and make payments on her credit cards. Her 2000 tax return was prepared by a professional tax preparer. She reported the $81,169 distribution but did not pay the 10% early withdrawal penalty. IRS sent a notice saying she was liable for the 10% penalty of $8,117 and the 20% accuracy related penalty under Section 6662(a).
The 20% accuracy related penalty applies when there is a substantial underpayment of taxes due to negligence or disregard of the tax rules and regulations. A substantial understatement as defined in Tax Code Section 6662(d)(1)(A) is when the underpayment exceeds either $5,000 or 10% of the tax required to be paid, whichever is greater.
Vulic’s tax liability before this assessment was $16,854, so adding the $8,117 of tax would trigger the substantial underpayment penalty.
Vulic decided to fight this in Tax Court and represented herself. She argued that “she was forced to withdraw the distribution because of economic hardship and to save her residence from foreclosure, and, therefore, should not be liable for the additional tax (the 10% penalty imposed by IRS).”
The Court of course noted that none of Vulic’s reasons mentioned above qualify as exceptions to the 10% penalty under Section 72(t) and concluded that she is liable for the 10% penalty on the $81,169 withdrawal.
However Vulic did win on the accuracy-related penalty, which at 20% could have been devastating to her. The Court ruled that the accuracy-related penalty would not be imposed. The Court recognized that Vulic really had no idea of the tax laws involved and stated in as nice a way as possible: “It is clear to the Court that petitioner is unsophisticated as to tax matters.” The Court noted that she did have a professional tax preparer that she believed filed an accurate income tax return.
Vulic had no chance of winning on the 10% early distribution penalty, because “economic hardship” is not an acceptable exception to the 10% early withdrawal penalty.
But it still paid for her to go to Court. By going to Tax Court she was relieved of the far more costly 20% accuracy-related penalty originally assessed by IRS.

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