Americans across the political spectrum seem to agree that retirement is a worthwhile venture. The recent economic recovery caused historic gains in the United States markets, erasing recession-caused losses, though perhaps not recession-caused pain. Under the current bull market environment, taxpayers may be more motivated and able to tap into retirement accounts to fund early retirements. Market volatility means that some taxpayers may find themselves in difficult financial circumstances in the future that might necessitate dipping into retirement accounts. In either case, the well-advised taxpayer may be able to withdraw money from his qualified retirement plan before age 59 ½ and avoid paying the 10 percent tax on early withdrawals by qualifying for one of the many exceptions. Keeping those exceptions in mind is essential for the advisor to properly guide taxpayers contemplating an early withdrawal to a penalty-free goal. This article will guide the reader through those many rules, not all of which are widely understood among professional ranks.
As a deterrent against early withdrawals (or an incentive to continued savings, depending on your perspective) the Internal Revenue Code (IRC) provides that withdrawals from “qualified retirement plans” are by default subject to a 10 percent tax on the amount of the withdrawal included in the account owner’s gross income. IRC § 72(t)(1). Many exceptions are then attached to the default rule. Consequently, taxpayers have options when avoiding the 10 percent tax.
To make a penalty-free withdrawal from a qualified retirement plan, the taxpayer may be served well by analyzing (1) whether the taxpayer has a qualified retirement plan, (2) whether any portion of the distribution would be subject to the 10 percent tax, (3) whether the taxpayer falls under one of the general lifetime exceptions, and finally (4) if the answers to (1), (2), and (3) are “yes,” “some portion,” and “no,” respectively, whether the taxpayer falls under one of the situational exceptions. Although the exceptions in some ways swallow the rule because of their sheer number, each exception has specific strict requirements that the taxpayer is required to meet. Failure to meet the requirements may lead to the imposition of the 10 percent tax plus interest from the date of the withdrawal to the date the 10 percent tax is paid. When a taxpayer wishes to take advantage of an exception, the taxpayer bears the burden of proving that the exception applies. Bunney v. Comm’r, 114 T.C. 259, 265 (2000).
Qualified Retirement Plans
For purposes of IRC § 72(t), the term “qualified retirement plan” means (1) a plan described in IRC § 401(a) that includes a trust exempt from tax under IRC § 501(a); (2) an annuity plan described in IRC § 403(a); (3) an annuity contract described in IRC § 403(b); (4) an individual retirement account described in IRC § 408(b) (including a Roth IRA described in IRC § 408A); (5) an individual retirement annuity described in IRC § 408(b) (including a Roth IRA described in IRC § 408A); or (6) any plan, contract, account, or annuity that was treated as a plan, contract, or annuity described in (1) through (5) at any time (regardless of whether it currently qualifies). IRC §§ 72(t)(1); 4974(c); Treas. Reg. § 54.4974-2, Q&A 2.
For many taxpayers, this translates roughly into IRAs, 401(k) plans, ESOPs, and Roth IRAs. It also might include profit sharing plans or other plans the taxpayer participates in as an owner or officer of a business. Each of the qualified retirement plans described in the definition has the distinction of being subject to rules restricting the ability of the taxpayer to take early withdrawals. The qualified retirement plans may also be subject to rules allowing early withdrawals. Even if an early withdrawal is allowed from a qualified retirement plan under the rules applicable to the particular plan (e.g., a hardship withdrawal from a 401(k) plan), if the withdrawal does not fall under one of the 72(t) exceptions it will still be subject to the 10 percent tax.
Portion Subject to 10 Percent Tax
The default rule applies a 10 percent tax on “the portion of such amount which is includible in gross income.” IRC § 72(t)(1). As a result, if no portion of the distribution is includible in the taxpayer’s gross income, then the default rule does not apply, and none of the exceptions is relevant. As a practical matter, an early withdrawal will rarely be entirely excluded from gross income. The following, in no particular order of importance, are a few, but not all, of the exceptions to income includability.
First, a distribution that is a return of the Roth IRA owner’s contribution is not included in gross income. Treas. Reg. § 1.408A-6, Q&A-1(b). For purposes of Roth IRA distributions, unlike traditional IRAs, distributions are deemed made first from the owner’s contribution and not from income in the account. Treas. Reg. § 1.408A-6, Q&A-8(a).
Second, rollover distributions from qualified retirement plans (including Roth IRAs) are not included in the taxpayer’s gross income. IRC §§ 402(c)(1), 403(a)(4), 403(b)(8), 408(d)(3), 408A(e). These non-inclusion rules also apply to spousal rollovers and rollovers to inherited IRAs from non-IRA retirement plans. IRC §§ 402(c)(9), 402(c)(11). An inherited IRA received from a deceased IRA owner may be rolled over in the sense that the transfer of an inherited IRA from one trustee to another trustee, each as trustee of the IRA, and each account held in the name of the decedent for the benefit of the beneficiary, are not included in the inherited IRA beneficiary’s gross income. Rev. Rul. 78-406.
Third, certain corrective distributions are not included in the recipient’s gross income, to the extent there was no income earned on the distributed amount. A corrective distribution typically occurs where a plan or an individual contributes more than the allowable amount to the qualified retirement plan during the year. The plan may make a corrective distribution before the end of the year after the plan year in which the excess contribution occurred. IRC § 401(m)(7)(B). In the case of an IRA, the individual may take a corrective distribution before the individual’s tax return is due for the year the contribution occurred. IRC § 408(d)(4).
Fourth, distributions made incident to divorce have a dual-track protection. The transfer of a taxpayer’s interest in an IRA to the taxpayer’s spouse under a divorce instrument is not considered a taxable transfer. IRC § 408(d)(6). In the non-IRA context, the transfer of the employee or plan participant’s interest in the plan to a spouse or former spouse under a qualified domestic relations order is not considered a taxable transfer. IRC § 402(4)(1).
Fifth, if a taxpayer makes a one-time election, a trustee-to-trustee transfer from an IRA (other than a SEP IRA or a SIMPLE IRA) to a health savings account (HSA), it will be excluded from the taxpayer’s gross income and thus not subject to the 10 percent tax. See IRC § 408(d)(9)(A). This exclusion is allowed only up to the excess of the annual contribution limitations for HSAs at the time of the contribution over any earlier HSA contributions (if the taxpayer elected this treatment when the coverage was self-only coverage and in a subsequent month in the same tax year the coverage is converted to family coverage). IRC § 408(d)(9)(C).
Sixth, non-taxable portions of a distribution are not included in gross income. This would include the portion of a contribution that was not allowed a deduction or a Roth contribution that was included in gross income. A distribution from a qualified retirement plan is taxed under IRC § 72. A distribution is taxed to the extent it comes from the income, and not investment, in the plan. The investment component is determined to be the amount of the distribution that bears the same ratio as (1) the total investment in the account bears to (2) the account balance. IRC § 72(e)(8). Where a plan was either recently funded and lacks income or is in a loss position in all respects, a distribution may be entirely from the investment and not from income if the contribution was non-deductible or included in gross income. See Schmalzer, TCM 1998-399 (allowing non-deductible contributions to an IRA made after 1986 to create basis in the IRA).
General Lifetime Exceptions
IRC § 72(t) provides two general lifetime exceptions to the 10 percent tax that become available to the taxpayer (or the taxpayer’s beneficiaries) simply by virtue of the passage of time. First, when the taxpayer reaches the age of 59½, any distribution thereafter is not subject to the additional tax. IRC § 72(t)(2)(A)(i). This exception is so pervasive that any withdrawal before age 59½ is often referred to as an “early withdrawal.” The IRC does not rank the exceptions, but this exception has the effect of making most of the other exceptions applicable only if the withdrawal occurred before age 59½. Second, when a distribution is made to the taxpayer’s beneficiaries or estate after the taxpayer’s death, those distributions are not subject to the 10 percent tax. IRC § 72(t)(2)(A)(ii). The statute thus provides a way around the 10 percent tax for anyone who either survives long enough or fails to survive.
When the taxpayer is not yet 59½ years old or deceased, the statute provides 11 exceptions that depend on the specific situation of the taxpayer. Unlike the general lifetime exceptions, the mere relation of the taxpayer to the timeline of their life is not enough to qualify for a situational exception. Additional considerations must be analyzed in order to trigger the benefits of the situational exceptions. Generally, the exceptions are cumulative, and where a taxpayer fails to meet the requirements of one, she may still be saved by another. When a taxpayer is claiming an exception, she is required to file a Form 5329 with her Form 1040 or 1040NR by the due date of that return, including extensions to file.
Series of Substantially Equal Periodic Payments (SSEPP). A taxpayer is not subject to the 10 percent tax when receiving a distribution from a qualified retirement plan as “part of a series of substantially equal periodic payments” at least annually for the life of the taxpayer or joint lives of the taxpayer and the taxpayer’s designated beneficiary. IRC § 72(t)(2)(A)(iv). The payments may begin anytime, unless they are made out of a trust qualified under IRC § 401(a) or on a contract purchased by an employer under 401(a), 403(a), 403(b), or from certain plans held by life insurance companies. IRC § 72(t)(3)(B). In those few cases, payment may begin only once the taxpayer has separated from service with the employer sponsoring the plan. Id.
Any modification of the SSEPP occurring within the later of five years of the beginning of the payments or the taxpayer turning age 59½ will cause the entire amount that would have been subject to the 10 percent tax to be subject to the 10 percent tax plus interest for the period beginning when the distribution was made and ending in the tax year of the modification. IRC § 72(t)(4)(A). Changes to the distributions due to the taxpayer’s death or disability are not treated as modifications. Id. Even if the taxpayer falls under the general lifetime exception by attaining age 59½, he may still violate the modification rule if the SSEPP distributions began less than five years previously.
The IRS has a strict view of the modification rules. The IRS has taken the position that a modification occurs if after the SSEPP is calculated in the first year there is any addition to the account balance (other than as investment gains and losses), any nontaxable transfer of a portion of the account balance to another retirement plan, or any rollover of the distribution amount that would cause the distribution to be nontaxable. Rev. Rul. 2002-62, § 2.02(e). A modification may arise under any other circumstance that changes the payment amount.
According to the IRS, annual distributions will qualify as a SSEPP if they are made under one of three methods: (1) the required minimum distribution method, (2) the fixed amortization method, and (3) the fixed annuitization method. Rev. Rul. 2002-62, § 2.01.
The required minimum distribution method calculates the annual payment each year based on the life expectancy tables (Appendix A in Rev. Rul. 2002-62 for the uniform lifetime table, and Treas. Reg. §§ 1.401(a)(9)-9, Q&A-1 and Q&A-3 for the single-life and joint-life tables, respectively) and the account balance. Rev. Rul. 2002-62, §§ 2.01(a), 2.02(a). The life expectancy and the account balance are redetermined each year. Id. If the taxpayer is using joint lives, then the life expectancy of the beneficiary is determined by using the age of the oldest beneficiary as of January 1 of the year being determined. Rev. Rul. 2002-62, § 2.02(b). If during the year the beneficiary is replaced with a different person, then in the next succeeding years the new beneficiary’s age is used. Id. The account balance is the balance that is reasonable under the facts and circumstances. Rev. Rul. 2002-62, § 2.02(d). As the payments are redetermined each year, the payment amounts change from year to year.
If there are multiple beneficiaries, their identities and ages are determined under the rules of IRC § 401(a)(9). Rev. Rul. 2002-62, § 2.02(b). Presumably, this means that the taxpayer may not have to take into account beneficiaries who would be successor beneficiaries (those who cannot benefit from the plan unless they succeed to the interest of another beneficiary). See Treas. Reg. § 1.401(a)(9)-5, Q&A-7(c). One also would presume that this means if the plan names a trust as its beneficiary, the rules applicable to look-through trusts may apply to determine if the trust beneficiaries, and their respective life expectancies, are required to be taken into account. See Treas. Reg. §§ 1.401(a)(9)-4, Q&A-5, 1.401(a)(9)-5, Q&A-7(c).
The fixed amortization method treats the payments as amortized loan payments from the account. The payment is based on the account balance and an interest rate equal to not more than 120 percent of the federal mid-term rate under IRC § 1274(d) for either of the two months preceding the month the distribution begins. Rev. Rul. 2002-62, § 2.01(b). The term of the “loan” would be the taxpayer’s life expectancy (determined in the same manner as the required minimum distribution method). Id. The amount of the payments is determined once, and the annual payments are then the same for each year.
The fixed annuitization method requires the taxpayer to annuitize the account balance. The annuity payment is determined by dividing the account balance by an annuity factor. Rev. Rul. 2002-62, § 2.01(c). The annuity factor is determined using the life expectancy of the taxpayer (determined in the same manner as the required minimum distribution method) and the interest rate (determined in the same manner as the fixed amortization method). Id. The annuity factors are based on Appendix B to Rev. Rul. 2002-62. Appendix B does not provide the actual factors but is a mortality table necessary to calculate the factors. Actuarial assistance or a program that can calculate the factors is necessary to use this method. As with the fixed amortization method, the amount of the payments is determined once and the annual payments are then the same for each year.
In pronouncing the available methods, the IRS also granted a lifeline for those taxpayers wishing to switch methods. Typically a change of methods would be a modification, but the IRS allows a taxpayer using the fixed amortization or the fixed annuitization methods to switch to the required minimum distribution method for the year of the switch and for all subsequent years. Rev. Rul. 2002-62, § 2.03(b).
As a technical matter, the three IRS methods of calculating a SSEPP may not be the only valid methods. This is because the three IRS methods are memorialized only in a revenue ruling, but the actual standard for an SSEPP is provided in the statute. The statutory language does not limit available methods to those the IRS approves, let alone those the IRS has enumerated as acceptable. As a result, it is conceivable a court may agree with a taxpayer that a method that does not fall within those the IRS has approved still meets the statutory standard. Relying on that technical argument, however, may be risky. From a planning perspective, the cautious taxpayer may want to consider structuring SSEPPs to fit within one of the three methods the IRS blessed.
Separation from Service. Distributions made to a taxpayer after the taxpayer is separated from service with his employer are exempt if the taxpayer was age 55 or older at the time of the separation. IRC § 72(t)(2)(A)(v). If the taxpayer was a qualified public safety employee and the distribution was from a qualified governmental plan that was a defined benefit plan, then this exception applies if the taxpayer was age 50 or older at the time of the separation. IRC § 72(t)(10). Logically, this exception does not apply to distributions from individual retirement accounts. IRC § 72(t)(3)(A).
Separation from service is not defined in the statute though it generally means that a person ceased employment for the employer. See Kim v. Comm’r, 679 F.3d 623 (7th Cir. 2012). The separation from service, however, is required to occur during or after the year in which the taxpayer turns age 55 (or 50). See Williams v. Comm’r, TC Summary Opinion 2008-53. Where the separation occurs before the year the taxpayer turns the necessary age, even if distributions are taken after the necessary age, this exception will not apply. See Owusu v. Comm’r, TCM 2010-186.
In order to apply the age 50 limit, the taxpayer is required to be a “qualified public safety employee.” Such an employee is an employee of the state, or a political subdivision of the state, who provides police protection, firefighting services, or emergency medical services for any area within the jurisdiction of the state or political subdivision. IRC § 72(t)(10)(B). Additionally, the distributions are required to come from a “governmental plan” that is a defined benefit plan. A governmental plan is a plan maintained for employees of the United States, any state or political subdivision of a state, or any agency or instrumentality thereof; certain plans established under the Railroad Retirement Act of 1935 or 1937, plans established under the International Organizations Immunities Act, and plans established by Indian tribal governments, subdivisions of Indian tribal governments, and agencies and instrumentalities providing essential government functions (e.g., not commercial functions). IRC § 414(d).
Disability. Distributions that are attributable to the taxpayer’s being disabled are also not subject to the 10 percent tax. IRC § 72(t)(2)(A)(iii). The term “disabled” is defined as “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof.” IRC § 72(m)(7). The regulations clarify that “substantial gainful activity” is the “activity . . . in which the individual customarily engaged prior to the arising of the disability or prior to retirement if the individual was retired at the time the disability arose.” Treas. Reg. § 1.72-17A(f)(1). Ultimately this is a determination made based on the facts and circumstances, though the regulations list impairments that ordinarily would be considered disabilities. Treas. Reg. § 1.72-17A(f)(2). These impairments include the loss of two limbs, cancer that is inoperable and progressive, mental diseases requiring institutionalization or constant supervision, and loss of sight, speech, and hearing. See id. As the impairment is required to be of a “long-continued and indefinite duration,” if it is remediable, it is not a disability. Treas. Reg. § 1.72-17A(f)(4).
Withdrawals from qualified retirement plans are considered attributable to the taxpayer’s being disabled whenever the taxpayer withdraws money for the purposes of financially supporting himself because his disability renders him unable to work. Thus, in PLR 9621043, a 49-year-old man was forced to retire from his endodontic practice because of an injury to his thumb and in turn could no longer financially provide for his family. Having taken out money from his qualified retirement account, the IRS held that, assuming he was disabled under IRC § 72(m)(7), such a distribution was attributable to his disability, and the distribution was exempt from the 10 percent tax.
A taxpayer who is able to engage in a substantial gainful activity despite his disability is not disabled for purposes of the disability exception. In re Fulton, 240 B.R. 854 (Bankr. W.D. Pa. 1999), Mr. Fulton injured himself after a fall but was able to continue working after this injury. Mr. Fulton claimed that he was disabled because of this injury and therefore should be exempted from the 10 percent tax. The Court held that Fulton was not disabled for purposes of the disability exception because he was able to engage in substantial gainful activity, namely, his work. Similarly, in Dwyer v. Comm’r, 106 TC 337 (1989), the taxpayer continued working as a stockbroker while receiving treatment for depression. Though Mr. Dwyer argued that his illness was a disability and that his work as a stockbroker resulted in substantial losses and thus was not gainful, the Court held that the depression, being treatable, was not a disability and his continued work was still a gainful activity, despite the losses.
In order to use the disability exception, the taxpayer is required to furnish proof of the disability in a form and manner the IRS requires. IRC § 72(m)(7). This includes providing the IRS with a physician’s opinion that the taxpayer has a disability that is expected to result in death or to be of long, continued, and indefinite duration. See Publication 590, “Individual Retirement Arrangements (IRAs).”
Medical Expenses. A distribution that is made from a qualified retirement plan for medical expenses is exempt from the 10 percent tax up to the maximum deduction for medical expenses under IRC § 213. IRC § 72(t)(2)(B). The maximum medical expense deduction is determined as though the taxpayer does not itemize deductions. Id.
All individuals are allowed to deduct expenses paid during the year for the medical care of the individual, the individual’s spouse, or the individual’s dependents who are not compensated for by insurance. IRC § 213(a). The deduction is limited, however, to the amount by which the expenses exceed 10 percent of the individual’s adjusted gross income. Id. The definition of medical care includes typical diagnosis and treatment but also includes essential travel and lodging expenses, long-term care services, medical insurance (including Medicare Part B insurance payments), and long-term care insurance. IRC § 213(d)(1). Payments for cosmetic surgery are not allowed as medical expense deductions. IRC § 213(d)(9).
The year the taxpayer pays the medical expenses and the year the taxpayer takes a distribution from the qualified retirement plan to pay the expenses are required to be the same year. See Duncan v. Comm’r, TCM 2005-171. Under the general rule that a taxpayer is required to prove eligibility for an exception, a taxpayer claiming the medical expense deduction is required to prove the amount of the medical expenses and that the taxpayer was eligible for the § 213 deduction. See McGraw, TCM 2013-152.
Medical Insurance Premiums. Unemployed taxpayers may exclude distributions to pay certain medical insurance premiums from the 10 percent tax. IRC § 72(t)(2)(D). This exception requires that (1) the taxpayer meet unemployment requirements, (2) the distributions meet timing requirements, and (3) the premium payments meet insurance requirements.
In order to meet the unemployment requirements, the taxpayer is required to be separated from employment and have received 12 consecutive weeks of unemployment compensation under any federal or state unemployment compensation law. IRC § 72(t)(2)(D)(i)(I). A self-employed taxpayer can qualify under these requirements if the taxpayer would have received federal or state unemployment compensation but for the fact the taxpayer was self-employed. IRC § 72(t)(2)(D)(iii). If the taxpayer is employed again for a period of at least 60 days, the taxpayer is no longer unemployed and cannot qualify for the exception. IRC § 72(t)(2)(D)(ii).
Under the timing requirements, the distribution is required to occur during the year the taxpayer is receiving the unemployment compensation or within the succeeding tax year. IRC § 72(t)(2)(D)(i)(II). The taxpayer is required to prove that the distributions were actually used to pay qualifying medical insurance premiums during this time period in order to claim the deduction. See Argyle v. Comm’r, TCM 2009-218.
Under the insurance requirements, the distribution is required to be used to pay premiums for medical insurance (including Medicare Part B insurance payments) or long-term care insurance. IRC § 72(t)(2)(D)(i)(III). The insurance can insure the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents. Id. For purposes of this exception, the term dependent includes individuals who are claimed as dependents themselves by other taxpayers, including a spouse with whom a taxpayer files a joint return, and is not limited to persons who have gross income below the personal exemption amount. Id. Because the definition of medical care under § 213 includes medical insurance premiums, this exception overlaps with the exception for medical expenses to some degree. Unlike the medical expense exception, however, this exception is not limited to the deduction limits in § 213.
Higher Education Expenses. IRC § 72(t)(2)(E) exempts from the 10 percent tax distributions from an IRA that are used to pay for qualified higher education expenses. As a reminder, an IRA can be either an individual retirement account or an individual retirement annuity. See IRC §§ 72(t)(2)(E), 7701(a)(37). The exception applies to qualified higher education expenses paid for the taxpayer, the taxpayer’s spouse, any child or grandchild of the taxpayer, or any child or grandchild of the taxpayer’s spouse. IRC § 72(t)(2)(7). The payments are required to be made to an “eligible educational institution” and for “qualified higher education expenses.” Id.
An eligible educational institution is an institution “described in section 281 of the Higher Education Act of 1965” and that “is eligible to participate in a program under title IV of such Act.” IRC §§ 72(t)(2)(7), 529(e)(5). These definitions have been interpreted to mean a college, university, or other postsecondary institution that is eligible to participate in the US Department of Education’s student aid program. Nolan v. Comm’r, TCM 2007-306. The Department of Education maintains a database of both domestic and foreign institutions that qualify for the student aid program.
The term “qualified higher education expenses” means “tuition, fees, books, supplies, and equipment required for . . . enrollment or attendance . . . at an eligible educational institution,” and certain special needs services expenses. IRC §§ 72(t)(2)(7), 529(e)(3). If the student is enrolled at least half of the normal full-time course load, then reasonable costs for room and board while attending the institution are also included, limited to the greater of the allowance of room and board at the institution or the charge for room and board by the institution for housing owned and operated by the institution. IRC § 529(e)(3).
As with other exceptions, the distribution and the payment for the qualified higher education expense is required to occur in the same year. Duronio v. Comm’r, TCM 2007-90; Lodder-Beckert v. Comm’r, TCM 2005-162. If the taxpayer is already taking SSEPP distributions, however, a distribution that qualifies for the higher education expense exception will not be a modification to the SSEPP. See Benz v. Comm’r, 132 TC 330, 336 (2009). The exception also only applies to distributions from an IRA. Consequently, a distribution from a 401(k) and any other plan will not qualify for the exception. See Uscinski v. Comm’r, TCM 2005-124.
First-Time Homebuyers. Distributions that are qualified first-time homebuyer distributions and that are made from IRAs are not subject to the 10 percent tax. IRC § 72(t)(2)(F). The term “qualified first-time homebuyer distributions” means a distribution that is used within 120 days of its receipt to pay qualified acquisition costs on a principal residence for which the taxpayer or the taxpayer’s spouse, or the child, grandchild, or ancestor of the taxpayer or the taxpayer’s spouse is a first-time homebuyer. IRC § 72(t)(8)(A).
Qualified acquisition costs are the costs of acquiring, constructing, or reconstructing a residence, including reasonable closing and financing costs. IRC § 72(t)(8)(C). A principal residence is a home that would be a principal residence for purposes of IRC § 121. IRC § 72(t)(8)(D)(ii). A “first-time homebuyer” is an individual (and her spouse) with no present ownership interest in a principal residence for two years before acquiring the principal residence for which the distribution was made. IRC § 72(t)(8)(D)(i).
Each taxpayer has a maximum lifetime exception limit under the first-time homebuyer exception of $10,000. IRC § 72(t)(8)(B). The lifetime limit applies for each taxpayer, so each spouse in a married couple has his own $10,000 limit. Presumably, that means a married couple making payments from community property may each be deemed to have contributed half of the distribution amount. In addition, assuming no prior distribution under this exception, it presumably means that a child of a taxpayer may take a $10,000 distribution from the child’s own IRA to fund a first-time home purchase for the child, and the child’s parents may take a total distribution of $20,000 ($10,000 from one parent and $10,000 from the other parent) from the parents’ IRAs and contribute the combined $20,000 to the child’s home purchase.
If a taxpayer receives a distribution under the first-time homebuyer exception and the purchase contract is cancelled, the taxpayer has 120 days (not the usual 60 days) to contribute the distribution into a new IRA in a rollover contribution. IRC § 72 (t)(8)(E).
Active Duty Military. The 10 percent tax does not apply to a qualified reservist distribution. IRC § 72(t)(2)(G)(i). A “qualified reservist distribution” is a distribution from an IRA (or employer contribution amounts to a 401(k) account or a 403(b) annuity or certain pension plan contributions) to a taxpayer who was a member of a reserve component of the military and called to active duty for more than 179 days and that is made during the period the taxpayer is called to active duty. IRC § 72(t)(2)(G)(iii). This exception applies only to taxpayers called to active duty after September 11, 2001.
Unlike any of the other exceptions, the taxpayer who received a qualified reservist distribution may recontribute the aggregate amount of the distribution to an IRA within two years after the end of the active duty period. IRC § 72(t)(2)(G)(ii). These contributions are not subject to the general contribution limits, but they are also not deductible. Id.
ESOP Dividends. Distributions that are dividends paid from an Employee Stock Ownership Plan (ESOP) are not subject to the 10 percent tax. IRC § 72(t)(2)(A)(vi). These are dividends paid on the employer’s stock held in the ESOP that are paid directly to the ESOP participants or their beneficiaries within 90 days of the close of the plan year. See IRC § 404(k)(2)(A). If the dividend, at the election of the plan participant, is reinvested in the ESOP in employer securities, the dividend no longer will qualify as an exception to the 10 percent tax. Notice 2002-2, Q&A-7.
Distributions Due to a Tax Levy. Perhaps so as not to add insult to injury, a distribution that is made from a qualified retirement account that is subject to levy under IRC § 6331 is not subject to the 10 percent tax. IRC § 72(t)(2)(A)(vii). The exception applies only when the IRS exercises its levy power. It does not apply when the taxpayer otherwise takes a distribution and uses the distribution to pay off a federal tax liability. In analyzing whether to pay a tax liability from a qualified retirement plan and trigger the 10 percent tax, the taxpayer may want to consider the difference between the 10 percent tax and the additional interest that will accrue on the liability until the likely time of levy. In addition, whether the distribution is before or a consequence of a levy, the distribution from the qualified retirement plan will be includible in the taxpayer’s gross income, regardless of the 10 percent tax. See IRC § 402(a). Consequently, the taxpayer may also need to consider the income tax liability (both federal and state) on a payment before levy and the loss of tax-free appreciation on any amount withdrawn before a levy.
Qualified Domestic Relations Orders (QDRO). Finally, any distribution to an alternate payee pursuant to a QDRO is not subject to the 10 percent tax. IRC § 72(t)(2)(C). This exception does not apply to distributions from an IRA, which are covered by separate rule. IRC § 72(t)(3)(A); see also IRC § 408(d)(6) (excepting transfer of interest in IRAs from gross income inclusion). A QDRO is any judgment, decree, or order, including an approval of a property settlement agreement, made pursuant to a state domestic relations law, which grants to an “alternate payee” the right to receive all or a portion of the benefits payable under a taxpayer’s qualified retirement plan. IRC § 414(p)(1). A QDRO must clearly specify the names and mailing addresses of the taxpayer and alternate payee, as well as the amount or percentage of the qualified retirement plan’s benefits the alternate payee is supposed to receive. IRC § 414(p)(2). A QDRO must also meet other requirements enumerated in IRC § 414(p).
The availability of this exception hinges on the existence of a valid QDRO. See Bougas III v. Comm’r, TCM 2003-194. Thus, if the court order does not specify a party as the alternate payee, the order, while possibly being a valid domestic relations order, may not be a QDRO and not afford the QDRO exception to the 10 percent tax. See Simpson v. Comm’r, TCM 2003-294. If the QDRO is valid, then the distribution is required to be made directly to the alternate payee. See Hartley v. Comm’r, TCM 2012-311; Simpson v. Comm’r, TCM 2003-294.
Roths and Other Exceptions
A distribution from a Roth account or a Roth IRA is not included in gross income if it is a qualified distribution. IRC §§ 402A(d)(1), 408A(d)(1). As a result, qualified distributions are not subject to the 10 percent tax. A “qualified distribution” is any distribution that is (1) made on or after the taxpayer attains age 59½, (2) made to a beneficiary or the estate of a deceased taxpayer, (3) attributable to a taxpayer being disabled (under the rules discussed above for the disability exception), and (4), in the case of a Roth IRA, made to a taxpayer in a distribution that meets the requirements of the first-time homebuyer discussed above. IRC §§ 402A(d)(1), 408A(d)(2)(A). Regardless of whether a distribution meets the definition of a qualified distribution, if the payment is made within five years of the taxpayer’s contribution to the Roth account or Roth IRA, or, in the case of a Roth account, within five years of the taxpayer’s contribution to an account rolled into a Roth account, the distribution will not be a qualified distribution. IRC §§ 402A(d)(2)(B), 408A(d)(2)(B). As a result of these Roth rules, any distribution that is not a qualified distribution will be subject to the 10 percent tax, unless it meets one of the exceptions discussed above.
The 10 percent tax also does not apply to certain distributions of excess contributions or to withdrawals from eligible automatic contribution arrangements, and it is periodically waived as part of disaster relief. See IRC §§ 401(k)(8)(D), 401(m)(7), 402(g)(2)(C), 414(w)(1)(B), 1400Q(a)(1), and Notice 2005-92.
Although the 10 percent tax is meant to be a barrier to early withdrawals from qualified retirement plans, the options for avoiding it are numerous and strictly circumscribed. The taxpayer’s professional advisors may provide a valuable service in educating the taxpayer on the requirements of the exceptions. In doing so, the advisor may help the taxpayer avoid the many traps the strict requirements of the exceptions set for the unwary.