While Sympathetic, Tax Court Finds No Financial Hardship Exception to IRA Early Withdrawal Penalty
The Tax Court held that distributions from a taxpayer's IRA in 2011 to support herself and her children, after she was laid off from her long-time job and was unable to find another one, were subject to the Code Sec. 72(t) early withdrawal penalty tax. While "sympathetic to her financial straits," the court found that that none of the statutory exceptions were available to the taxpayer, and thus the distributions were subject to the Code Sec. 72(t) penalty tax. Elaine v. Comm'r, T.C. Memo. 2017-3.
In June 2009, Candace Elaine was laid off from her job of 23 years as a call center manager with a mutual fund company. At that time and during the year in issue, she was a single mother, raising two daughters on her own without support from anyone else. On account of the economic downturn, she was unable to find another job, and remained unemployed for several years.
To provide for her own subsistence and that of her daughters, Elaine made a series of withdrawals from her individual retirement account (IRA). During 2011, at which time she was not yet age 59she received four distributions totaling $119,000 from that account. For each distribution, the bank issued Elaine a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. According to the IRS's wage and income transcript for Elaine's 2011 tax year, each Form 1099-R reported that the entire distribution was taxable and was an early distribution with "no known exception." Each Form 1099-R also reflected federal income tax withheld.
Elaine prepared and filed timely her Form 1040 for 2011. She reported taxable IRA distributions of $119,675, among other items of income (including unemployment compensation) and loss. After itemized deductions totaling $45,148 and exemptions totaling $11,100 (for herself and her daughters), Elaine reported taxable income of $33,184 and total tax of $4,119. She did not report the additional tax on early distributions from her IRAs, and did not attach Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to the return. After reporting her federal income tax withheld, Elaine claimed an overpayment of $4,849, which was refunded to her in May 2012.
On June 3, 2013, the IRS proposed changes to Elaine's 2011 return attributable to her not reporting any additional tax on her IRA distributions. Elaine timely responded to the IRS and explained that, because the IRA was her only means of income to pay bills and support herself and her daughters, she thought that the distributions from her IRA would fall under a financial hardship exception. In subsequent correspondence to the IRS, Elaine continued to plead financial hardship.
The IRS subsequently issued a notice of deficiency which assessed a Code Sec. 72(t) 10 percent penalty tax on the 2011 distributions from Elaine's IRA, as well as a substantial understatement of tax penalty. Elaine timely petitioned the Tax Court. She stated that she believed that the amounts withheld from her IRA distributions included a "10% federal and a 10% state penalty," and asked that she not be held liable for the tax and the penalty on the ground that, during 2011, she was experiencing financial hardship.
Taxpayers can withdraw assets from their traditional IRA at any time. However, distributions before age 59are considered early distributions. Generally, an individual who takes an early distribution from a traditional IRA must pay a 10 percent additional penalty tax. Under Code Sec. 72(t)(1), the 10 percent penalty tax applies only to the part of the distribution that the individual must include in gross income, and is in addition to any regular income tax on the amount.
However, an individual who receives a distribution before age 59may not be subject to the penalty tax under several circumstances, such as if:
- The individual has unreimbursed medical expenses that are more than 10% of his/her AGI.
- The distribution is not more than the cost of medical insurance due to a period of unemployment.
- The individual is totally and permanently disabled.
- The individual is the beneficiary of a deceased IRA owner.
- The individual is receiving distributions in the form of an annuity.
- The distribution is used for qualified higher education expenses.
- The distribution is used to buy, build, or rebuild a first home.
- The distribution is due to an IRS levy on the plan.
Before the Tax Court, Elaine testified that the distributions were essentially her only means of income to pay bills and to support herself and her daughters. She indicated that she used a portion of the distributions to pay monthly medical insurance premiums and her student loan debt. While the court noted that the relevant statutory exceptions to the 10 percent penalty tax include distributions to an unemployed individual for health insurance premiums, as well as distributions for qualified higher education expenses, it found Elaine's testimony regarding the insurance premiums and student loan debt to be too general, and noted that she was unable to produce any documentation substantiating her testimony.
After concluding that Elaine took withdrawals from her IRA because of financial hardship, the Tax Court repeated what it has held on many other occasionsthat there is no exception under Code Sec. 72(t) for financial hardship (e.g., see Dollander v. Comm'r, T.C. Memo. 2009-187; Milner v. Comm'r, T.C. Memo. 2004-111; and Gallagher v. Comm'r , T.C. Memo. 2001-34). While "sympathetic to taxpayer's financial straits," the Tax Court stated that it could not disregard the express and unambiguous wording of the statute. Since none of the enumerated statutory exceptions applied to Elaine, all distributions from her IRA in 2011 were subject to the Code Sec. 72(t) additional penalty tax.
However, the Tax Court also held that Elaine was not liable for the substantial understatement of tax penalty under Code Sec. 6662. This was based on the (1) common misunderstanding among taxpayers that financial hardship is an exception to the Code Sec. 72(t) penalty tax; and (2) the fact that, "for whatever reason," the IRS closed an examination of Elaine's 2010 tax return for the same Code Sec. 72(t) issue without change. Because of that, Elaine "proceeded under that misunderstanding not only with respect to 2011 but apparently with respect to 2012 as well."