IRAs, 401(k)s and similar retirement savings vehicles have experienced phenomenal growth over the past several years, both in terms of the number of participants and in the sheer dollar value of those accounts. Unfortunately, the opportunities to run afoul of the qualified withdrawal rules also have grown. These missteps by account owners have not gone unnoticed by either the Internal Revenue Service or the courts.

Failed rollovers and disqualified distributions have become one of the handful of "big-dollar" mistakes that can be made by the "average" taxpayer. Not only is a disqualified distribution or rollover immediately taxed as income but, often, a 10 percent penalty is also imposed.

The rules on what constitutes a withdrawal subject to the 10 percent penalty are sometimes tricky, at least in part because their application by the IRS and the courts has not always followed logic. While the outcome may not always appear to be entirely "fair," however, they nevertheless are defensible by a strict reading of the Tax Code. Tax advisors would do well to learn from several recent situations that fall under this category.

Type of plan matters

The type of plan from which early withdrawals are taken makes a difference as far as whether the IRS applies the 10 percent penalty.

Under Code Sec. 72, a distribution from an individual retirement account will not be subject to the 10 percent early withdrawal penalty tax if the distribution is made:

* For medical expenses in excess of 7.5 percent of adjusted gross income or for health insurance premiums while unemployed;

* For qualified higher education expenses; or,

* For qualified first-time home purchase expenses.

Withdrawals for higher education and first-time home purchases are restricted to IRAs. The medical expense exemption, however, covers all plans. While other hardship withdrawals may be allowed under a plan, they are generally subject to the 10 percent penalty. (A hardship distribution in this case is one that is necessary because of the employee's immediate and heavy financial needs, which is necessary to satisfy the financial need.) Application of the 10 percent penalty on a failed rollover, on the other hand, may be abated at the IRS's discretion.

Recently, the Tax Court in Milner, TC Memo. 2004-111, held that there was no support for "an umbrella hardship exception" applicable to unqualified distributions on a case-by-case basis. It reasoned that it was Congress' intent to encourage saving for retirement by discouraging early distribution.

'For the taxable year'

Under Code Sec. 72(t)(2), otherwise disqualified withdrawals from IRAs may avoid the 10 percent penalty if they are made to cover medical expenses or qualified higher education expenses "for the taxable year." The IRS and the Tax Court have been reading this exception to include a precise timing requirement that can give taxpayers trouble.

In Beckert, TC Memo 2005-162, part of the distributed amount was used to pay down credit card debts, which were incurred to pay qualified higher education expenses for the two years prior to the distribution. The court held that amount not to be excepted from the 10 percent penalty. The higher education expense exception requires that qualified expenses be incurred directly in the tax year of the distribution. "We must apply the law as Congress enacted it and may not rewrite it," concluded the court.

In Ambata, TC Summary Opinion 2005-93, the taxpayer withdrew $17,200 from her IRA in 2002, planning to use the money for college expenses that year. However, she ended up not enrolling until 2003, at which time she used the money for tuition. Citing Beckert, the Tax Court again refused to grant the taxpayer any leeway, even though use of the funds took place within the same academic year as the withdrawal. The withdrawal and expense did not match up within the same tax year.

While the Code does not require tracing of the withdrawn funds to payment of the expense, it does require the withdrawal and the payment to be in the same tax year. Students and taxpayers with dependents who are students should be careful, therefore, not to withdraw from an IRA toward the end of December to get the funds ready for payment of tuition not due until January.

While the rules for education deductions and credits allow for expenses paid during a tax year, in connection with an academic term beginning during the year or the first three months of the next year, taxpayers should be cautioned not to presume that such a grace period applies to plan withdrawals. Pre-payment of tuition in December, for example, may not be considered yet a current "expense;" clearly a withdrawal in December and a payment in January may be considered a mismatch of tax years.

Medical deductions face a similar timing problem, exacerbated by emergencies in which payment not covered by insurance must be made quickly, often using a credit card, until arrangements can be made to withdraw the funds. An emergency medical situation late in the year, for which payment is made in December and withdrawal is made from an IRA or similar plan in January, technically does not meet the "for the taxable year" withdrawal requirement and can be subject to the 10 percent penalty.

Loan instead of withdrawals

Being fiscally responsible by taking out a loan to pay medical expenses, rather than making a withdrawal, did not go unpunished in Duncan, TC Memo 2005-171, again because of the "for the taxable year" requirement. In that case, the taxpayer took out a loan against the balance of her 401(k) plan in 2000 to pay for medical expenses incurred that year. In the next year, the loan was accelerated because she left her employment. Unable to repay the loan at that time, it was deemed a distribution in 2001.

The Tax Court held that the loan became a distribution only when the time allowed for repayment after separation from service ended, rather than when the funds were made available. Only those medical expenses incurred in the tax year in which the loan became a distribution could protect the deemed distribution from the 10 percent penalty.

Bankruptcy no excuse, either

In White, TC Summary Opinion 2005-62, the taxpayer borrowed money from his 401(k) plan to pay for his daughter's college education, promising to repay the loan in level installments within five years. However, in the third year of the loan, the taxpayer filed for bankruptcy, and, after receiving confirmation of his Chapter 13 plan, the taxpayer's employer stopped withholding the loan repayment amounts from the taxpayer's wages.

Since the taxpayer failed to repay the loan as required, the balance due when he stopped making the repayments was a taxable distribution and subject to the early distribution penalty. Although the taxpayer argued that he should not have to pay the penalty because he was prevented from making the loan repayments by his Chapter 13 bankruptcy plan, the court found that there is no specific exception for the taxpayer's situation.

60-day rollovers

The IRS is given mixed reviews for leniency when a financial institution is responsible for blowing the 60-day deadline for completing rollovers. Unlike distributions, the 10 percent penalty on late rollovers may be excused at the IRS's discretion. Rev. Proc. 2003-16 provides the IRS with the general guidelines for approving waivers.

In LTR 200445034, a taxpayer won a reprieve from the 60-day IRA distribution rollover rule when his financial institution miscalculated his required minimum distribution and the taxpayer did not discover the error until after the normal

60-day period for rolling over or returning distributions had ended. Likewise, in LTR 200504042, a rollover to a non-IRA was due to the failure of a bank employee's inexperience, which the bank acknowledged to the IRS in writing. After receiving the bank's acknowledgment, the IRS agreed to waive the 60-day deadline.

In LTR 200504037, however, the taxpayer did not find the IRS lenient. There, a father of four college students took money out of his IRA to pay his daughter's tuition, intending to replace the funds from her student loan within the 60-day rollover period.

However, the processing of his daughter's student loan took longer than expected, and the money was not available in time to make the 60-day deadline. The IRS examined Rev. Proc. 2003-16 and the legislative history of Code Sec. 72. It determined that the 60-day limitation was intended to facilitate portability between accounts, and not to create short-term loans. Since the distribution was not for an anticipated purpose, the taxpayer was not eligible for a waiver of the 60-day deadline.


The assumption that withdrawals from IRAs and similar accounts for medical expenses, higher education expenses or first-time home buying will be penalty-free should not be made automatically.

The requirement that the withdrawal and the use of the money fall within the same tax year is a trap for the unwary. Use of loans to put this timing requirement back in sync also cannot be relied upon.

And relying an a kindly Uncle Sam to set things right also can be unrealistic, since the IRS's power to abate the penalty is limited, both by statute and by its willingness to forgive taxpayer miscalculations.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.

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