Take-Away: Rolling funds from a qualified plan to an IRA on termination from employment, and then taking a distribution from the IRA prior to age 59 ½, will cause the IRA owner to incur the 10% additional tax in addition to the income tax on the distribution.

Background: The Tax Code imposes a 10% additional tax on distributions from qualified retirement accounts. [IRC 72(t).] However, there are some exceptions to this general rule. For example, if the participant-IRA owner is age 59 ½, then the additional tax is not imposed. [IRC 72(t)(2)(A)(i).] Yet another exception to the additional tax is when an employee separates from service after attaining age 55 years. [IRC 72(t)(2)(A)(v).] Unfortunately, the separation from service exception does not apply to distributions from a traditional IRA. This can present a problem for a plan participant who terminates employment and rolls their qualified plan account balance into a traditional IRA, and later accesses that IRA through a distribution. A recent Tax Court decision demonstrates this potential tax ‘trap.’

Catania v. Commissioner, No. 13332-19, Tax Court Memo 2021-33 (March 15, 2021)

  • Facts: John worked for Home Depot and participated in the Home Depot 401(k) plan. John retired from Home Depot in 2014 at which time he rolled his 401(k) account into a traditional IRA at Vanguard. At the time of his retirement, John was age 55. In 2016, at age 57,  John withdrew $37,000 from his Vanguard IRA to pay for repairs to his home and for other living expenses. Vanguard issued to John a 1099-R reporting the $37,000 distribution, which John dutifully reported on his Form 1040 for the year. In 2019, the IRS issued to John a Notice of Deficiency in the amount of $3,700- the 10% additional tax because John took an IRA distribution prior to attaining age 59 ½.
  • Tax Court: The Tax Court Judge found that John owed the additional tax, even though he was age 57 and had received the funds upon his termination of employment with Home Depot. To reach this result the Judge noted:

As a general rule, the IRS’s determination of a taxpayer’s liability in a Notice of Deficiency is presumed correct. Accordingly John bore the burden to prove that the determination of tax liability was incorrect.

The separation from service exception to the additional tax under IRC 72(t)(2) is not applicable to early IRA distributions, just from qualified plans. Emerson v. Commissioner, Tax Court Memo, 2000-137.

“On brief petitioner suggests that the section 72(t)(2)(A)(v) exception should apply to the distribution at issue because he was 55 years old when he retired from Home Depot. As stated above, section 72(t)(2)(A)(v) is not applicable to premature IRA distributions. See 72(t)(3)(A).Although petitioner had a section 401(k) plan when he worked for Home Depot, he transferred the funds from that account to a traditional IRA at Vanguard in 2014. Because he withdrew the distribution at issue from a traditional IRA in 2016, section 72(t)(2)(A)(v) does not apply…..Although we are sympathetic to petitioner’s situation, we are not a court of equity, and we cannot ignore the law to achieve an equitable end.”

Comment: Once again we find a situation where some arcane Tax Court rules apply to distributions from qualified plans that do not apply to distributions from IRAs. Just like other rules, e.g. qualified charitable distributions, are available to be taken from IRAs, but not qualified plan accounts. These varying sets of rules often confuse taxpayers, and sometimes even their advisors. In the end, the general feeling is often one of gotcha, where is seems disparate rules are intentionally put in place not so much to prevent abuses so as to trap taxpayers. If Congress ever gets around to simplifying the Tax Code, as each Congress promises, retirement plan distributions would be a good place to begin, especially as Baby Boomers enter into their retirement years.