Early withdrawals from retirement accounts should be discouraged. Withdrawals reverse the retirement savings process, and early distributions are the most expensive type, as they are subject to both income tax and the 10% early withdrawal penalty. The tax and penalty combined can erode half of an early distribution.
In the real world, however, people sometimes must access their retirement funds early.
While income tax can't be avoided on early distributions from retirement plans, the 10% early withdrawal penalty sometimes can be. Financial advisers should do all they can to help clients avoid the penalty by making sure a distribution qualifies for one of the many possible exceptions.
Unfortunately, not all exceptions apply to all plans. Many of those who pay the 10% penalty do so because the exception they used didn't apply to their distribution.
Overall, the 10%-penalty exceptions fall into three categories: Ex-ceptions that apply to distributions from both company plans and individual retirement accounts, exceptions that apply only to -distributions from IRAs, and exceptions that apply only to distributions from company plans.
The age-55 separation-from-service exception, for instance, applies only to distributions from company plans, not to those from IRAs. Not knowing which exception applies to which plan can get a client — and their adviser — into trouble.
Many tax court cases reveal that taxpayers had to pay the 10% early-withdrawal penalty because the exception they claimed didn't apply to the plan from which they took their distribution.
The record shows that the costliest errors involve exceptions for first-time home buyers and for higher education. While these exceptions apply only to distributions from IRAs and never from company plans, taxpayers keep going to court to fight the rule — and lose every time.
Let's look at a few examples.
Christine L. Gibbons, a schoolteacher, withdrew $67,553 from her 403(b) plan and used the money to pay for college education expenses. She paid the income tax, but not the 10% penalty, because she thought that the exception for higher education applied to distributions from company plans.
It doesn't, as Ms. Gibbons found out in court. The exception to the 10% penalty for higher education expenses applies only to distributions from IRAs and never to distributions from plans (Christine L. Gibbons v. Commissioner; T.C. Summary Opinion 2006-106; No. 5464-05S; July 13, 2006).
Likewise, accountant Keith Lamar Jones left his firm to begin studying full time for his doctorate. 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.
Mr. Jones thought he was exempt from the 10% penalty because 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 had he wanted to, and that the difference between a 401(k) and an IRA is "a matter of form."
Mr. Jones lost his case because there is a difference: these exceptions apply only to distributions from IRAs and not from other qualified plans (Keith Lamar Jones v. Commissioner; T.C. Summary Opinion 2005-173; No. 6936-04S; Nov. 29, 2005).
Jeanette M. Kimball withdrew $17,222.69 from her qualified plan in 2000 to pay for medical treatments that began that year, though most of the bills were paid in 2001. She claimed that since her family used the funds for medical expenses, they qualified for the medical expense exception to the 10% penalty and didn't owe a $1,722 tax penalty.
The Internal Revenue Service disagreed, as did the Tax Court, where Ms. Kimball lost her case. In its decision, the court stated that a medical deduction for a tax year is allowed only for "the expenses paid during the taxable year" for medical care, and only "to the extent that such expenses exceed 7.5% of adjusted gross income" (Jeanette M. Kimball, et vir, v. Commissioner; T.C. Summary Opinion 2004-2; No. 16640-02S; Jan. 8, 2004).
The lesson is that if clients plan to use the medical-expenses or higher-education exceptions, they must have paid related expenses in the same year as the distribution was made from the company plan or IRA. The medical-expenses exception applies to both company plans and IRAs, while the higher-education exception applies only to IRA distributions.
Ed Slott, a certified public accountant in Rockville Centre, N.Y., has created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.