The Tax Court ruled that paying higher education expenses from an IRA was not a modification of a taxpayer’s annuity payments from the IRA that would have made the payments subject to the 10% additional tax on early distributions.
Generally under IRC § 72(t), distributions received from an IRA before a taxpayer reaches age 59½ are subject to the penalty. But there are many exceptions. They include distributions rolled over in a timely manner; made due to death or disability; made to a qualified military reservist called to active duty; or used to buy, build or rebuild a first home. Taxpayers with certain medical expenses or qualified higher education expenses also qualify for the exception, as do taxpayers who receive a series of substantially equal payments over their life expectancy or the joint lives or life expectancies of the taxpayer and beneficiary (the annuity exception).
The annuity exception requires that taxpayers use a method approved by the IRS and receive at least one distribution annually. If the annual payments are modified (for any reason other than death or disability) before age 59½ or within a five-year period that begins with the date of the first payment before age 59½, the 10% penalty tax is applied to distributions received before age 59½ (IRC § 72(t)(4)).
Kim Benz owned an IRA while she was employed. In 2002, she ended her employment and elected to receive a series of payments of $102,311 (based on her life expectancy) on or before Jan. 15 each year, starting in 2002. In 2004, before reaching age 59½, she received her annual annuity payment of $102,311 and two additional distributions totaling $22,500. Benz and her husband included the $22,500 as income on their 2004 return but did not apply the penalty tax because they had qualified educational expenses of $35,221 in 2004. The IRS disagreed and assessed the 10% penalty tax on $89,590 (the total amount received, $124,811, minus the qualified educational expenses of $35,221). The Service determined that by taking the two additional payments, she had impermissibly modified her series of payments before she reached age 59½, and therefore the substantially equal periodic payment exception was no longer effective for the 2004 distribution. The Benzes petitioned the Tax Court for relief.
The IRS argued in Tax Court that a taxpayer who elects a series of substantially equal periodic payments is not allowed any further distributions within the first five years of the election irrespective of whether the distribution would qualify for another statutory exception to the section 72(t) tax, unless the employee dies or becomes disabled. The court rejected this position and stated that the language of section 72(t)(2)(E) permits taxpayers to qualify for more than one of the exceptions in a given tax year. It further found that there was no indication in the legislative history of section 72(t) that Congress intended the election of the annuity method to preclude the use of other exceptions to the penalty. The court also concluded that the purpose of the penalty, to discourage early withdrawals from retirement savings accounts, is not defeated if a taxpayer withdraws money from an IRA under more than one exception.
Gregory T. and Kim D. Benz v. Commissioner , 132 TC no. 15
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.