IF FINANCIAL HARDSHIP CAUSES YOU TO TAKE AN EARLY IRA DISTRIBUTION WHAT TAXES CAN YOU EXPECT TO PAY


           Have you ever needed a significant amount of cash on an emergency basis?  Perhaps, you were sued or needed to file a lawsuit and needed a retainer for an attorney.  Or maybe, you lost your job and could not afford the rent.  Perhaps, NSTAR was threatening to turn off your gas and/or electricity.  Physical and mental illness frequently results in financial hardship.  All too often, divorce destroys the financial health of both spouses.  The possible emergencies are endless.  And if you have an IRA liquidating it early, before the age of 59 1/2, just might be your only viable option.  Because IRAs are simple to liquidate and the proceeds are available quickly, for many people an early IRA distribution is the only way to get through a crisis.   Unfortunately, for most the price of an early distribution in terms of income, additional and other taxes can be daunting.           

          The IRS has general rules for taxing IRA distributions and early IRA distributions with some limited exceptions.  If an individual deducted an IRA contribution from taxable income at the time of contribution (Traditional IRA), future withdrawals from that IRA are taxable as ordinary income at the time of withdrawal.  If the individual did not deduct the contribution when made (Roth IRA), future withdrawal are taxable as to interest and appreciation of the contributed funds but not taxable as to amounts originally contributed.  To discourage the use of IRA distributions for purposes other than retirement , the IRS assesses a 10% additional tax in addition to the ordinary income tax due on the distribution.  And if the correct tax is not paid, the IRS may tack on one more tax, a 20% accuracy-related penalty. 

          In certain situations, an exception to the additional tax may apply.  The ten generally applicable exceptions are as follows:

                     1.  Rollovers from an IRA to another qualified retirement plan;
                     2.  Distributions to an estate or beneficiary at the IRA owner's death;
                     3.  Distributions on account of a disability;
                     4.  Distributions as a part of a series of equal payment for life;
                     5. Qualified first time home buyer distributions;
                     6. Distributions for qualified higher education expenses;
                     7. Distributions for medical insurance premiums paid while unemployed;
                     8.  Certain medical expenses paid in excess of 7.5 % of adjusted gross income;
                     9.  Distributions as a result of an IRS levy;
                    10. Distributions to a qualified reservist.

          A common misconception is that an emergency financial hardship is an exception.  As you can see, financial hardship is NOT on the list.  On January 3, 2017, the United States Tax Code in Elaine v. Commissioner of Revenue, T.C. Memo 2017-3, imposed the 10% additional penalty on an unemployed divorced woman of two who was not receiving any child support.  She took early IRA distributions because she had no other way to feed her children. The taxpayer argued the additional tax was not due because she withdrew the monies due to a financial hardship.  She further argued, the IRS had audited her return the prior year and never raised that issue. The Court held that I.R.C. § 72 (t) imposes the additional tax and if the monies are not used for one of the above enumerated purpose, then it is due. Financial hardship simply is not on the list, and the IRS will not deviate from the list.

          Not  only is ordinary income tax and an additional tax due, but the IRS may also impose a 20% accuracy-related penalty under I.R.C.§ 6662 (a) in the event of a "substantial understatement.  Substantial understatement is defined as a deficiency amount equal to 10% or more of the total tax due on the return or $5,000.00.  The accuracy related penalty can be avoided if the taxpayer had reasonable cause to believe the return was correct and acted in good faith.  In the Elaine case, the Court found Ms. Elaine was not a professional tax preparer and reasonably believed financial hardship was an exception to the additional tax rule.

           If you or someone you know is taking early IRA distributions, make sure the monies are being used
 for one of the above listed purposes and that detailed records of how the monies are being used are being maintained.