Money invested in retirement accounts reaps the benefits of tax-deferred earnings and is therefore good for tax planning purposes. But putting money into retirement accounts limits the availability of funds because they are generally subject to the Sec. 72(t) 10% addition to tax on distributions taken before reaching age 59½ (as well as being included in taxable income). Your clients may want to take their money out of these accounts early, so you should know how to do that without paying the 10% tax. The exceptions to the tax on early distributions also differ depending on whether the money is withdrawn from a qualified plan or an IRA.
In addition to the exceptions discussed in this article, one way to avoid the tax is by taking a 60-day rollover "loan" from a retirement account. While not technically a loan, distributions are tax-free if the taxpayer reinvests the funds in a retirement account within 60 days, even if the funds are reinvested in the same account. If the taxpayer cannot return the funds to a retirement account within 60 days, the distribution will become subject to income taxes and the 10% tax. Announcements 2014-15 and 2014-32, which the IRS issued to conform its position with the Tax Court's decision in Bobrow, T.C. Memo. 2014-21, say that after 2014 taxpayers are allowed only one rollover in every 12-month period, no matter how many IRA accounts they hold. (For more on Bobrow and the IRS's reaction, see "Tax Matters: Rollover Contribution to Second IRA Disallowed," JofA, May 2014, page 61.)
Also, the 10% tax generally does not apply to distributions of basis (i.e., distributions of amounts in the account that have been previously taxed). Basis distributions from traditional IRAs and qualified plans are determined by the ratio of total basis to fair market value, multiplied by the amount of the current-year distribution. However, nonqualifying distributions from Roth IRAs first come from basis and then from earnings. Thus, early distributions from Roth IRAs are generally completely tax-free and penalty-free unless they exceed the basis in the Roth IRAs. An exception is any distribution of basis in a Roth IRA that was derived from a conversion rollover from a traditional IRA within the prior five years. A distribution of this conversion basis is subject to the 10% tax but is not included in the taxpayer's gross income. Nonqualifying distributions from Roth IRAs that exceed basis are subject to income tax and the 10% tax unless one of the exceptions applies.
The exceptions from the 10% tax in Sec. 72(t) depend on whether the retirement plan is a qualified plan or an IRA. Qualified plans include defined benefit and defined contribution plans offered by employers, such as 401(k) or 403(b) plans. IRAs include traditional and Roth IRAs as well as SEP and SIMPLE IRAs.
EXCEPTIONS AVAILABLE TO BOTH QUALIFIED PLANS AND IRAs
Death or disability of the taxpayer
When a taxpayer dies, his or her retirement assets generally are transferred to one or more beneficiaries. The beneficiary must recognize income when he or she receives distributions from the inherited retirement assets. These distributions are not subject to the 10% tax. Beneficiaries are often required to begin withdrawing funds shortly after inheriting the retirement assets (see "Required Minimum Distribution Alternatives for IRA Beneficiaries," The Tax Adviser, March 2011, page 178).
A taxpayer who is permanently and totally disabled can also take distributions without being subject to the 10% tax. Disabled taxpayers must furnish proof that they are unable to engage in any substantial gainful activity due to physical or mental impairment that is either terminal or expected to be long-term and indefinite. For these purposes, substantial gainful activity refers to the activity in which the individual customarily engaged before the disability arose or before retiring if the individual was retired at the time the disability arose. Regs. Sec. 1.72-17A(f) provides examples of conditions that ordinarily are considered in determining disability, including:
- Loss of two limbs;
- Progressive diseases that result in the loss or atrophy of a limb;
- Diseases that result in a major loss of heart or lung reserve;
- Inoperable and progressive cancer;
- Brain damage;
- Mental disease requiring constant supervision; and
- Loss of vision, speech, or hearing.
These conditions do not guarantee that an individual will be considered disabled but will be used to determine whether he or she can continue to be employed in his or her customary substantial gainful activity or a comparable activity.
Taxpayers should work with the custodian of the retirement plan to ensure the Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reports distribution code 3, indicating a distribution was disability-related. The custodian may specify the type of documentation it requires to prove the existence of the disability before it authorizes the early distribution. In addition, taxpayers should always keep that proof with their tax information in case of an IRS audit.
The type of proof necessary depends on the taxpayer's facts and circumstances. According to Sec. 72(m)(7), "an individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require"; however, the IRS has not specifically defined acceptable proof. Reasonable evidence could be a letter or affidavit from the taxpayer's physician that states the taxpayer has a permanent or indefinite disability that keeps him or her from gainful activity and that cannot be remedied by medication or other acts by the taxpayer. In addition, taxpayers could show treatment plans completed and/or Social Security disability payments received. Even with a physician's statement, the IRS and courts may deny the disability exemption if the taxpayer has continued to be employed, could remedy the disability through his or her own actions, or is expected to fully recover and therefore is not permanently disabled.
Substantially equal periodic payments
Substantially equal periodic payments (SEPPs) received over the taxpayer's expected life are not subject to the 10% tax if the payments continue for the longer of five years or until the taxpayer reaches age 59½. The IRS provides several safe-harbor methods for calculating the allowable payment (see "Substantially Equal Periodic Payments From an IRA," The Tax Adviser, Oct. 2008, page 670). SEPPs taken from a Roth IRA before age 59½ are not qualified distributions under this rule and are included in taxable income but will not be subject to the 10% tax.
A taxpayer's allowable medical expenses on Form 1040, U.S. Individual Income Tax Return, Schedule A, Itemized Deductions, reduce the amount of distributions subject to the 10% tax. Allowable medical expenses are those that exceed 10% (7.5% through 2016 for taxpayers who have turned 65) of the taxpayer's adjusted gross income (AGI), even if the taxpayer claims the standard deduction. The taxpayer needs to establish only that he or she incurred qualified medical expenses in the tax year in which the distribution from the retirement plan occurred and does not need to prove that he or she used the funds from the distribution to pay the medical expenses.
The IRS has the authority under Sec. 6331 to seize taxpayer assets, including retirement accounts, to recover unpaid taxes and penalties. This type of distribution is especially painful for a taxpayer because the amount the IRS seizes is also taxable income (except for basis), but the seized funds are not subject to the 10% tax.
Qualified reservists are those called to active duty after Sept. 11, 2001, for a period greater than 179 days or an indefinite period. For these withdrawals to be classified as qualified distributions, the qualified reservist must take the distributions during his or her active duty period. While these distributions are taxable income, they are not subject to the 10% tax. Qualified reservists can repay the distributions to an individual retirement plan within two years of the end of their active duty without regard to the usual limitations on contributions. Since the repayment contributions aren't deductible and instead create basis, it may be advisable for taxpayers to maximize their regular retirement contributions before repaying these amounts.
EXCEPTIONS AVAILABLE TO QUALIFIED PLANS ONLY
Distributions to former employees are not subject to the 10% tax if the employee is at least 55 years old before separating from service to the employer. Distributions can be from defined benefit or defined contribution plans. Distributions continue to be excluded from the penalty even if the former employee returns to work, as long as the separation was indefinite. This exception does not apply to an IRA, even if the IRA consists entirely of funds rolled over from a qualified employer plan.
The minimum separation age is reduced to 50 if the former employee is a qualified public safety employee and the distribution is from a defined benefit governmental plan. Qualified public safety employees are police, firefighters, and emergency medical providers who are employees of a state or political subdivision of a state.
Qualified domestic relations order
Distributions made to a person other than the account owner under a qualified domestic relations order (QDRO) are taxable to the person receiving the distribution (unless the money is rolled over into a retirement plan) but are not subject to the 10% tax. QDROs are common in divorce property settlements. (For more on QDROs, see "QDROs Demand the Attention of CPAs," JofA, Aug. 2014, page 60.)
Dividends from an ESOP
Sec. 404(k) provides a C corporation a tax deduction for "applicable dividends" paid to participants on securities held by an employee stock ownership plan (ESOP). If the corporation qualifies for this deduction, then the dividends are not subject to the 10% tax, even if the employee receives them in cash. However, if the dividends are reinvested in qualifying employer securities at the employee's election, they are not eligible for this exception.
Federal phased retirement program
Certain federal civil service employees are eligible for a phased retirement annuity while continuing to work part time and a composite annuity upon full retirement. Payments under either of these plans are not subject to the 10% tax.
EXCEPTIONS AVAILABLE FOR IRAs ONLY
Health insurance for the unemployed
Distributions to individuals who received unemployment benefits from a state or federal program may be exempt from the 10% tax to the extent the money was used to pay health insurance premiums for the individual and his or her family. To be eligible for this exception, distributions must occur in a tax year during which the individual has received unemployment compensation for 12 consecutive weeks or in the succeeding year. Distributions are not eligible if they are made after the individual has been reemployed for 60 days.
Example 1: M was laid off from her employer in 2015 and started receiving unemployment benefits on Nov. 1, 2015. If she continues to receive unemployment through the week of Jan. 17, 2016, she is considered unemployed for purposes of the exception to the 10% tax since she has received unemployment benefits for 12 consecutive weeks. If M remains unemployed, any distributions made during 2015, 2016, and 2017 that are not in excess of the health insurance premiums paid during those years will not be subject to the 10% tax. However, if M gets her job back or gets another job, distributions made subsequent to 60 days from her reemployment date will be subject to the tax. So if M becomes employed on March 1, 2016, she can no longer take distributions under this exception after April 29, 2016.
Self-employed individuals are generally not eligible for unemployment benefits. Nevertheless, IRA distributions used to pay health insurance premiums are exempt from the 10% tax under the same rules as for employees. To qualify for the exception, the self-employed individual must have been eligible for unemployment benefits except for the fact that he or she was self-employed. For instance, a taxpayer who is unemployed because his or her sole proprietorship went out of business may be eligible for this exception.
Higher education expenses
IRA distributions are not subject to the tax to the extent they do not exceed the taxpayer's qualified educational expenses. The qualified educational expenses can be for either the taxpayer or the taxpayer's spouse, children, or grandchildren. Qualified expenses include tuition, fees, books, supplies, and equipment, as well as room and board for students who are enrolled at least half time. Qualified expenses are reduced by any financial assistance or a payment for an individual's educational expenses (other than a gift, bequest, devise, or inheritance) that is excluded from gross income. For example, scholarships, grants, and tax-free employer tuition assistance reduce the amount of qualified educational expenses.
Example 2: P is a full-time student at a university. His total qualified expenses for 2016 are $20,000, which includes room and board and tuition. He receives a tax-free scholarship for $5,000 that is used to pay tuition included in the $20,000 of expenses. In this case, $15,000 can be withdrawn from IRAs without incurring a 10% tax. The IRA withdrawal can be made by P's parents or grandparents, as well as by P (but the cumulative withdrawals cannot exceed $15,000). The exclusion from the 10% tax does not limit the parents' or grandparents' ability to claim other educational tax benefits, such as education credits or a tuition deduction.
Distributions made to a qualified first-time homebuyer are not subject to the 10% tax. The maximum that a taxpayer can exclude is $10,000, and the taxpayer must use the distribution within 120 days to purchase or construct a principal residence for the taxpayer, spouse, child, grandchild, or ancestor of either the taxpayer or the spouse. The $10,000 is a lifetime limit that applies to the individual receiving the distribution. Thus, a taxpayer and spouse could each receive $10,000 from his or her own IRA to apply toward the purchase of the same primary residence. A first-time homebuyer is an individual who has not owned a home (or whose spouse has not owned a home) during the two-year period ending on the date of acquisition of the new home. If the acquisition date is delayed or canceled after the money is distributed, the taxpayer can roll over the money into an IRA within 120 days of the distribution. In this case, the taxpayer excludes the distribution from income in the same manner as with any other qualified rollover.
Example 3: L and M, who are both under age 59½, purchase their first home in 2015 for $100,000. They can each withdraw $10,000 from their own IRAs free of the 10% tax to apply toward the purchase. However, if M withdraws $20,000 from his IRA and L withdraws none, then $10,000 of M's withdrawal will be subject to the 10% tax since the $10,000 limit applies to each individual taxpayer. Because the $10,000 is a lifetime limit, if L and M each withdraw $10,000 from his or her own IRA in 2015, they will not be able to take additional penalty-free distributions in the future to apply toward the purchase of a home for their children or grandchildren. If L and M take a qualified distribution to apply toward their first home on June 1, 2015, but the sale falls through, they have 120 days from the date of distribution (Sept. 29) to recontribute the funds into the IRAs without incurring a 10% tax or including the amount in income.
Taxpayers should consider the potential consequences of the exception from the additional tax before rolling over qualified plans into IRAs. For instance, if employees separate from service at age 55, they can immediately begin withdrawing funds penalty-free from their employer's qualified plan. However, if they roll over that plan into an IRA, they must wait until they are 59½ to take distributions without paying the additional tax.
Retaining funds in a qualified plan can potentially be beneficial in the case of a divorce. A divorced taxpayer is not subject to the 10% tax on a distribution to an alternate payee from a qualified plan, as long as the distribution is pursuant to a QDRO. However, an individual cannot rely on the QDRO exception to avoid the additional tax on a transfer of IRA assets to the individual's spouse, because the exception applies only to qualified plans.
On the other hand, there are sometimes benefits for transferring qualified plans to IRAs. Distributions from IRAs to pay college expenses and first-time homebuyer expenses are not subject to the additional tax. If the taxpayer needs retirement funds for these expenses, assets could be transferred from a qualified plan to an IRA before ultimately being distributed to the taxpayer.
Taxpayers should not be discouraged from investing in retirement plans for fear of the 10% tax. The tax-deferred earnings in the retirement account will quickly compensate for any additional tax that the taxpayer may have to pay in the future. The number of years in which the tax deferral will fully compensate for the additional tax depends on the investment return and the marginal tax rate.
Finally, advisers should generally discourage clients from withdrawing money from their retirement accounts unless absolutely necessary, even if they can avoid the 10% tax. As taxpayers live longer and Social Security benefits become more uncertain, clients should be focused on doing everything they can to help increase the amount they have available for their retirement needs, including not withdrawing funds from retirement plans before they retire.
About the authors
Jillian K. Poyzer (firstname.lastname@example.org) is an instructor, and Timothy R. Yoder (email@example.com) is an assistant professor of accounting and business administration, both at the College of Business Administration at the University of Nebraska—Omaha, in Omaha, Neb.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at firstname.lastname@example.org or 919-402-4828.
"When a Client Leaves or Loses a Job," Feb. 2012, page 40
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