January 17, 2023
New SECURE Act 2.0 Penalty Exceptions
Take-Away: The SECURE Act 2.0 created two new exceptions to the early distribution excise tax for domestic abuse and financial emergencies. While ‘better than nothing’ neither provides much in the way of financial relief.
Background: We know that there exists a list of exceptions in the Tax Code that provides relief from the 10% excise tax for taking a distribution from a retirement account prior to the account owner being age 59 ½. Reasons like first-time homebuyers, higher education costs and disability are all statutory exceptions to the early distribution penalty. While these distributions are nonetheless subject to income taxes, the 10% excise tax is waived for the eligible distribution. The SECURE Act 2.0 added two new exceptions to the early distribution penalty that applies to distributions from both IRAs and qualified retirement plan accounts, e.g. 401(k) accounts.
Domestic Abuse Victims: Starting in 2024 (not 2023) is a new exception from the excise tax for victims of domestic abuse that occurred within the previous 12 months. The abuse must be by a spouse or domestic partner, which tends to limit the exceptions availability. The new exception enables the victim to self-certify that he/she experienced domestic abuse and he/she can withdraw the lesser of (i)$10,000 (indexed for inflation) or (ii) 50% of the balance of the retirement account.
Domestic Abuse Defined: The Act defines domestic abuse is defined as physical, psychological, sexual, emotional, or economic abuse, including efforts to control, isolate, humiliate, or intimidate the victim’s ability to reason independently, including by means of abuse of the victim’s child or another family member living in the household.
Repayment: Any distributions that are taken under this domestic abuse exception can be repaid to the same, or another, retirement account over 3 years, and income taxes on repaid dollars will be refunded.
Financial Emergencies: While the Tax Court over the years has not been receptive to claims of financial emergencies when account owners sought waivers of the 10% early distribution penalty when they faced a financial hardship, the SECURE Act 2.0 opens the door, albeit only a small crack. Beginning in 2024 (not 2023) the 10% penalty will be waived for financial emergencies, but with lots of restrictions. Like the domestic abuse exception an account owner can self-certify that their emergency is real, i.e. no longer the need to provide an independent financial analysis of the lack of available funds other than the retirement account.
Personal or Family Emergency: The account owner must face unforeseeable personal expenses or immediate financial need relating to a personal or family emergency.
One Per Calendar Year: The distributions relying on the financial emergency exception is limited to one per calendar year.
No More than $10,000: The maximum amount eligible to be withdrawn under the exception is $1,000.
Must Be Paid Back Before Another Distribution: No amounts may be taken as emergency distributions in the following three years, or until the amount withdrawn as an emergency exception is (i) either repaid, or (ii) future salary deferrals (for qualified plans) or contributions (for IRAs) meet or exceed the amount of the personal expense distribution. In other words, the retirement account must be made whole before any future financial emergency distributions using the new exception can be taken.
Conclusion: I guess these new exceptions are ‘better than nothing,’ but a measly$1,000 exception to pay for financial emergencies is hardly going to be classified as a windfall to any account owner in dire need of accessing funds.