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George F. Bearup, J.D. Senior Legal Trust Advisor

1-Oct-20

Qualified Distributions for Birth and Adoption Expenses

Take-Away: The SECURE Act created an exception to the 10% penalty otherwise imposed on a distribution from a retirement account for expenses that are incurred in a birth or an adoption. The IRS just issued guidance on how these new rules will be interpreted and enforced.

Background: The SECURE Act added another exception to the Tax Code which normally imposes a 10% penalty for distributions from a retirement plan prior to the account owner attaining age 59 ½. There is a list of reasons or purposes for which a distribution from a qualified plan or IRA can escape the early distribution penalty. Those exceptions include the following:

  • Unreimbursed medical expenses;
  • Health insurance premiums while unemployed;
  • Permanent disability;
  • Higher education expenses (including room and board if the owner is a student more than 50% of the time; and
  • To purchase, build, or rebuild a first home for an ancestor (parent or grandparent) of oneself, a spouse, a child, grandchild, or a spouse’s child or grandchild [IRS Publication 590-B]

Birth and Adoption Expenses: The SECURE Act added to the above list of excepted distributions from the 10% penalty for early distributions for qualified birth and adoption expenses. These exceptions from the early distribution penalty are expenses associated with the birth of a child and the adoption of a child, however the distributed funds do not have to actually be traced to pay those identified expenses.

Notice 2020-68: This new exception to the 10% penalty was addressed in more detail in IRS Notice 2020-68, issued in August. Some of the basics with regard to this new penalty exception follow.

  • Effective Date: This exception is effective January 1, 2020.
  • Elective: The employer sponsor of a qualified plan does not have to offer qualified birth or adoption distributions to plan participants.
  • Income Taxes: While a qualified birth or adoption distribution is free from the 10% early distribution penalty, income taxes will still have to be paid on the distribution from the IRA or qualified plan account.
  • Repayment: The SECURE Act also permits the recipient of a qualified birth or adoption distribution to repay all or a part of the distribution at any time to an eligible retirement account. Unfortunately, the Notice does not indicate how any repayments will be handled.
  • Limited Amount: This exception to the 10% early distribution penalty is limited to $5,000 per child. Each child qualifies for his/her eligible birth distribution or eligible adoption distribution.
  • Eligible Adoptee: An eligible adoptee includes an individual who has not attained age 18 or a person who is physically or mentally incapable of self-support. The strict definition of disability that permits  the disability exception from the 10% early distribution penalty for the account owner is used to describe an eligible adoptee who is physically or mentally incapable of support.
  • Spouse’s  Child: However, the definition of eligible adoptee does not include an individual who is the child of the taxpayer-distributee’s spouse.
  • Source of Funds: The exception applies to distributions from IRAs and qualified plan accounts (defined contribution plans.)
  • Deadlines: To qualify for the exception from the 10% early distribution penalty, the distribution must be made from the IRA or the qualified plan during the one-year period that begins on the date on which the child is either born or the child’s adoption is legally finalized.
  • Reporting: The retirement account owner must include the name, age and taxpayer identification number of the child or eligible adoptee on the income tax return for the year in which the distribution is made.

Examples: How some of these new qualified birth and adoption distribution rules work are demonstrated by the following examples.

  • Brad and Jennifer become parents of twins on June 15, 2020. Both parents are under the age 59 ½. Each of Brad and Jennifer can withdraw $10,000 penalty-free from their retirement accounts (Brad from his 401(k) account and Jennifer from her IRA.) Both distributions are qualified birth distributions.
  • Archie and Edith, in their late 40’s, are foster parents for 15 year old Gloria and 24 year old Mike. Archie and Edith wish to adopt both Gloria and Mike. Mike is incapable of self-support, as defined by the statute, i.e. Mike is disabled.  The adoptions are finalized in the probate court on August 15, 2020. Archie and Edith can each withdraw $10,000 from their respective IRA accounts [$20,000 in the aggregate] before August 15, 2021. Both Gloria and Mike are eligible adoptees; Gloria is under the age of 18 at the time of her adoption and Mike is mentally incapable of self-support. Thus, the full $20,000 can be withdrawn without the payment of any early distribution penalty by Archie and Edith.
  • Fred and Ethel, age 38,  have been married for 10 years. Ethel has a son, Ricky, age 12, from her first marriage. On May 20, 2020 Fred legally adopted Ricky. Fred cannot take a qualified adoption distribution from his IRA because Ricky is his wife’s son.
  • Charlie, age 47, is a participant in ABC company’s 401(k) plan. Charlie’s wife gives birth to a child on July 15, 2020. The ABC plan does not offer qualified birth or adoption distributions. However, Charlie is eligible for an in-service distribution which is expressly authorized under the ABC 401(k) plan given his age and years of service under the plan. Accordingly, even though the ABC 401(k) plan does not permit qualified birth and adoption distributions, Charlie can treat a plan distribution of $5,000 from the ABC 401(k) plan as a qualified birth and adoption distribution on his income tax return. Charlie’s distribution will be taxable, but Charlie will avoid the 10% early distribution penalty.

Conclusion:  Births and qualified adoptions are just two more additions to the relatively short list of exceptions to the 10% penalty for early distributions to an account owner prior to age 59 ½. While these exceptions may help encourage young couples who struggle to pay the costs of childbirth or an adoption, not to be overlooked is the fact that these are currently taxable distributions of retirement funds that were originally set aside [exploiting income tax deferral] for the account owner’s retirement years. As such, accessing a retirement account to pay birth or adoption expenses should probably a ‘last resort’ source of funds.