Beware the early distribution penalty

Withdrawals before age 591/2 from plans and IRAs that are used to pay medical bills are generally exempt from the 10% early distribution penalty. But not all medical expenses qualify.

In a recent tax case, early IRA withdrawals used to pay medical expenses were still subject to the 10% penalty (Cheryl Lynne Ireland v. Commissioner; T.C. Summ. Op. 2015-60; No. 5649-1, Oct. 15, 2015).

In 2011, when she was 47, Cheryl Lynn Ireland withdrew $5,294 from her IRA. The IRA custodian reported the distribution on Form 1099-R and withheld Federal income tax of $529 from the distribution. Ms. Ireland filed her federal income tax return. Although she included the wages that she earned in 2011 in her gross income and claimed a credit for the income tax that the hospital, where she worked, withheld from her pay, she did not report the IRA distribution or the related 10% early withdrawal penalty. The IRS determined a deficiency of $1,324 in Ms. Ireland’s federal income tax for 2011. She disagreed and brought the case to Tax Court.

PENALTY APPLIED

The Tax Court had two issues to decide. The first was whether Ms. Ireland was liable for federal income tax on the unreported distribution from her IRA. The second was whether the 10% early distribution penalty applied.

The court held that Ms. Ireland’s IRA distribution was taxable. It ruled that distributions from an IRA normally constitute gross income subject to federal income tax, although there are several exceptions to this rule. Exceptions include rollovers, transfers incident to divorce and qualified charitable distributions (QCDs).

Ms. Ireland maintained that her accountant informed her that there was no need to include the distribution in her taxable income because she used the funds to pay her son’s medical expenses. The court held that was not correct, and stated that Ms. Ireland could not exclude the IRA distribution from her taxable income.

The court also held that Ms. Ireland’s IRA distribution was subject to the 10% early distribution penalty. Taxable IRA distributions taken before the IRA owner reaches age 591/2 are generally subject to the 10% early distribution penalty. There is an exception for distributions used to pay deductible medical expenses (paid in the same year as the IRA distribution). This includes unreimbursed expenses paid during the year for medical care of the taxpayer, a spouse or a dependent.

DEDUCTABLES ONLY

The Court concluded that Ms. Ireland was not eligible for this exception, even assuming that she did use the funds in question to pay her son’s medical expenses, because she did not claim her son as a dependent for the year at issue and failed to demonstrate that her son met the definition of a dependent under the law.

To be exempt from the 10% penalty on a plan or IRA distribution used for medical expenses, only unreimbursed medical expenses that would have been claimed as an itemized deduction for income tax purposes qualify. To qualify as a deductible medical expense, it must be paid for the taxpayer, his or her spouse or dependents.

There are exceptions when a person does not qualify as a dependent on the tax return but still qualifies as a dependent to deduct medical expenses, but that was apparently not the case here.

While sympathetic to her difficult financial situation and the fact she received some bad accounting advice, the court said it could not cite general financial hardship as an exception to 10% penalty and was obligated to apply the law as written. 

RULES ARE VERY STRICT

Using an IRA distribution to pay medical expenses will not necessarily allow a client to avoid taxation on the distribution. Medical expenses can be an exception to the 10% early distribution penalty but the rules are very strict. Be sure your client qualifies before claiming the exception.

If a client has to tap an IRA before reaching age 591/2, general financial hardship will not relieve them of taxation or the 10% early distribution penalty. There is no such thing as a hardship withdrawal from an IRA. While there are hardship distribution provisions in many company plans, they are only to allow the participant to withdraw funds earlier than otherwise allowed. The distribution would still be taxable and subject to the 10% penalty.

Note 2013 changes to 10% penalty exception for medical expenses.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.