Why IRAs aren't the same as 401(k)s

You would think that an attorney would know that an individual retirement account isn't a 401(k), but Young Kim didn't and it cost him dearly. Here are the facts in the case. In 2005, at age 56, Mr. Kim left his job as a partner in a law firm. Under the terms of his former employer's retirement plan, he was entitled to a distribution, which he rolled over tax-free to an IRA. The next year, Mr. Kim withdrew about $240,000 from the IRA. He paid the necessary federal income taxes, but not the 10% early-distribution penalty tax standard for withdrawals before 591/2. Mr. Kim's accountant, who prepared his 2006 federal tax return, didn't report the 10% penalty, which, coupled with the fact that the 10% penalty he owed was more than $5,000, led to an accuracy-related penalty for substantial underpayment of taxes. The dispute went to the Tax Court, which determined that about $36,000 of Mr. Kim's early withdrawal was used to pay for his daughter's and his own higher education expenses at the London School of Economics, which he attended after leaving his law practice. Because higher education is an exception to the early distribution penalty for IRAs, those amounts weren't subject to the 10% penalty. However, the Tax Court ruled that the rest of the funds — about $204,000 — were used for purposes subject to the 10% penalty. Additionally, the court ruled that Mr. Kim owed a $4,000 penalty for a substantial underpayment of taxes. He disagreed and brought his case to a federal appeals court and asked it to rule that he owed no 10% early-distribution penalty or at least that he didn't owe the $4,000 accuracy-related penalty.

RELYING ON THE CODE

Mr. Kim's arguments relied first on Internal Revenue Code Section 72(t)(2)(A)(v), which states that the 10% penalty doesn't apply to a distribution from a qualified retirement plan “made to an employee after separation from service after attainment of age 55.” However, the distribution occurred from an IRA, not a qualified retirement plan. Although Mr. Kim could have taken a penalty-free distribution from the law firm's plan after separation, he chose to roll those funds into an IRA. Had he not rolled those funds over, he could have used the age 55 rule and not paid a 10% penalty. The 7th U.S. District Court of Appeals in Chicago noted that Internal Revenue Code section 72(t)(3)(A) specifically says that the age 55 rule doesn't apply to IRAs.

RATIONAL OR NOT

Mr. Kim insisted that this seeming inconsistency “makes no sense.” His argument was that because he could have taken the money from the law firm's retirement plan without the 10% penalty, why should it matter — or make any difference from a tax point of view — if the funds went to an IRA before being withdrawn? It matters, according to the Internal Revenue Code, the appeals court ruled. In addition, because Mr. Kim's accountant omitted the 10% penalty from his tax return and that amount ($20,000) was more than $5,000, the court ruled that the accuracy-related penalty also applied. While there is an exception for reasonable basis or substantial authority for the taxpayer's position, unfortunately for Mr. Kim, the appeals court held that he provided no reasonable basis or substantial authority that his IRA is the same as an employer plan. Therefore, he had to pay the 20% accuracy-related penalty of more than $4,000. This case reminds financial advisers that the age 55 rule doesn't apply to IRAs. Other taxpayers have gone to court over this same issue and have lost as well. In addition to the 10% early-distribution penalty, advisers should be aware that the costly 20% accuracy-related penalty also can be assessed in situations such as this one. Ed Slott, at irahelp.com, is a certified public accountant and IRA distribution expert.