IRA Alert: Tax court shoots down medical exception

Recently, the Tax Court ruled that an individual was liable for the 10% early-distribution penalty on a retirement plan distribution. The man didn't qualify for the medical-expense exception to the 10% early-distribution penalty be-cause he couldn't prove anything that he claimed. He also was hit with the 20% accuracy penalty for substantial underpayment of income taxes. In 2009, William McGraw had a retirement account that was in-vested in an annuity. An acquaintance of his offered to help him roll over his funds into a better-performing annuity, and in April 2009, he received a check for $67,440. Mr. McGraw was surprised to receive the check, because he was expecting the money to be moved right to the new annuity and not be cashed out. Even though he realized that no rollover was done, he deposited the check into a non-retirement bank account. Mr. McGraw learned soon afterward that his wife was pregnant. Because his wife's first pregnancy had been difficult, he thought he might need the retirement funds to pay for pregnancy-related ex-penses and opted to keep the funds in his bank account. Mr. McGraw didn't report the $67,440 distribution as taxable income on his 2009 federal tax return, nor did he pay the 10% early-withdrawal penalty. He also didn't report any deductible medical expenses. Upon review of his return, the Internal Revenue Service said that he owed $23,659 in federal income taxes including the 10% penalty and a 20% accuracy-related penalty of $4,732 for substantially underpaying his taxes.

Tax court decision

Mr. McGraw brought the issue to the Tax Court. Before trial, he conceded that he had failed to include the $67,440 distribution in his income, but he continued to claim that he wasn't liable for the 10% early-distribution penalty because of the exception for medical expenses, which exempts retirement distributions from the 10% penalty to the extent that medical expenses can be deducted, regardless of whether the taxpayer itemizes deductions. In court, Mr. McGraw said that his “best recollection” was that he paid total out-of-pocket medical expenses of $5,000 to $6,000 for his wife's high-risk pregnancy. That is a far cry from the $67,440 distribution he took, so when the court asked him what he did with the rest of the distribution, he said he used it to get a room ready for the baby and “for all the baby things that you do.” Mr. McGraw family had medical insurance at the time of his wife's pregnancy, but he didn't know what costs had been covered. The court ruled that he was subject to the 10% early-distribution penalty. Mr. McGraw wasn't eligible for the medical-expense exception to the penalty. It gave three reasons for its decision. First, Mr. McGraw couldn't prove any amount of medical expenses. Although he itemized his deductions, he didn't report any deductible medical expenses on his Form 1040, Schedule A. Second, even if Mr. McGraw did have qualifying medical expenses, he failed to prove that they were unreimbursed, which is required by the tax code. He had health insurance, but he didn't know the extent to which his wife's pregnancy costs were covered by their insurance. Finally, even if Mr. McGraw did have proof that he paid for some unreimbursed medical expenses, the amount didn't exceed the floor in effect in 2009. That year, the law allowed a medical expense deduction only to the extent that unreimbursed medical ex-penses exceeded 7.5% of adjusted gross income. On Mr. McGraw's original 2009 tax return, he reported AGI of $54,351. After adding back the $67,440 retirement plan distribution and other adjustments determined by the IRS, it produced a corrected AGI of more than $122,000.

Below AGI floor

As such, even if Mr. McGraw had been able to substantiate the expenses and showed that they weren't reimbursed, the total expenses still would have been below 7.5% of his AGI and therefore neither deductible nor eligible to help relieve any of the 10% early-distribution penalty. The court also decided that he was liable for the 20% accuracy-related penalty for substantial understatement of income tax under Internal Revenue Code Section 6662 due to his failure to report the retirement plan distribution as gross income, and report and pay the 10% early-distribution penalty. Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group.