Confusing IRA Rules with Qualified Plan Rules

Take-Away: Individuals often confuse the distribution rules that are associated with IRAs with distributions from qualified plan accounts. Part of that confusion stems from the Department of Treasury’s vague definitions that can often lead to unexpected ‘gotcha’ income taxes and penalties.

Background: A special rule with regard to IRAs is the ability to take a distribution, penalty free, for the purchase of a home by a first time homebuyer. [IRC 72(t) (2) (F).] The distribution is subject to taxation, but if the funds are used toward the purchase of a home, the distribution is not subject to the 10% penalty for early distributions (if taken prior to age 59 ½.) The use of a distribution for a first-time homebuyer is not, however, an exception from the early distribution penalty if a qualified plan is the source of the distribution. The 10% early distribution penalty applies to any qualified retirement account. The exception when a distribution used by a first-time homebuyer is available to an individual retirement account. That distinction in the two terms [qualified retirement account –individual retirement account] was on display in a recent Tax Court decision.

Tax Court Decision: Soltani-Amadi v Commissioner, Tax Court Summary Opinion 2019-19 (August 8, 2019)

• Facts: The individual involved, age 55, was a participant in a 401(k) plan sponsored by her employer. In 2015 she took a modest $6,686 distribution from her 401(k) account in order to purchase a new home when her purchase financing came up a bit short. She claims that she was told by her plan administrator that since the funds were used to purchase a new home, there would be no tax imposed on the plan distribution. The withdrawn funds were clearly traced into the purchase of the first home she ever purchased. Following the advice she allegedly received from the plan administrator, she did not report the $6,686 on her 1040 tax return. Treasury assessed her $1,697 for the unreported distribution and imposed a 10% penalty on the amount that she withdrew from her 401(k) account.
• Result: The Tax Court affirmed the assessed income taxes and 10% penalty. In doing so, the Court stressed Congress’ intent with the 10% penalty, which is to deter distributions from qualified retirement accounts prior to actual retirement. The Court also distinguished between an individual retirement plan (an IRA account or IRA annuity) which are expressly excepted from the 10% penalty for first-time homebuyers, and qualified retirement plans (qualified plan accounts like 401(k) accounts) which are subject to the 10% penalty. [IRC 4974(c).] Since the taxpayer had the burden of proof, the Court found that she was not able to escape the imposition of the income tax or the additional 10% penalty.

Conclusion: Fortunately, for the taxpayer, the amount of the additional income tax and penalty was not insurmountable. Yet this Tax Court decision also shows how easy it is for a taxpayer, without any technical advice, to conclude that the first-time homebuyer exception accorded to an individual retirement plan would also be applicable to her qualified retirement plan distribution. Someday Treasury may provide to us clearer definitions, so that taxpayers [or their plan administrators] will not be led astray.