No Exception to Early Distribution Penalty for Financial Hardship
By Sarah Brenner, IRA Technical Expert
Follow Us on Twitter: @theslottreport
When you encounter tough economic times, you may be tempted to tap your retirement plan. If you are considering this, you will want to proceed carefully. If you are under age 59 ½, any distributions you take may be taxable and also subject to the 10% early distribution penalty. There is no exception to the penalty for financial hardship, despite a common misconception otherwise. A recent Tax Court case is an important reminder of the unfortunate consequence of believing such an exception is available. [Preston L. Kott v. Commissioner; T.C. Summ. Op. 2015-42; No. 30012-13S, July 14, 2015]
Preston L. Kott received distributions from his 401(k) plan. At the time of those distributions, he had not reached the age of 59 ½. He withdrew the amounts because of financial hardship. He was late with his mortgage payments and wanted to avoid foreclosure on his home. He did not pay the 10% early distribution penalty on the distribution. The dispute over whether it applied eventually went to the Tax Court. Kott argued that the 10% early distribution penalty should not be imposed because the distributions were due to financial hardship. The Tax Court disagreed with Kott. The Court said that no exception to the penalty exists for financial hardship. The Court acknowledged that hardship distributions from the 401(k) retirement plan to Kott were allowed, but said that this did not mean they were not subject to penalty.
This taxpayer’s unfortunate predicament is an important reminder. There is no exception to the 10% early distribution penalty for financial hardship. A distribution may be allowed from some company plans for this reason and you can take a distribution from your IRA at any time for any reason, including financial hardship. However, if you are under age 59½ financial hardship is not enough to avoid the penalty.
There is a very specific list of exceptions to the 10% early distribution penalty. Some apply just to IRAs. For example, you may take a penalty-free distribution from your IRA, but not your company plan, to purchase your first home or pay your child’s college tuition. Other exceptions apply only to company plans. If you were age 55 or older when you left your job, you may take penalty-free distributions from your company plan, but not your IRA. There are exceptions that apply to both. Penalty-free distributions are available to you from either your IRA or company plan if you are an active military reservist and certain conditions are met. No financial hardship withdrawal exception exists for either IRAs or company plans.
Over the years, many cases involving the mistaken belief that an exception to the 10% early distribution penalty exists have ended up in court. Courts have expressed sympathy for the the taxpayers involved but still have consistently imposed the penalty, just as this court did in this case. Courts have said that they cannot provide any relief because none exists in the law as it is written.
If you are experiencing money problems, think carefully about taking an early distribution from your retirement plan. Remember that no exception to the 10% early distribution penalty exists for financial hardship. If you are under age 59 ½, your distribution may be subject to both taxation and the penalty if no exception applies. The rules are complicated and have confused many. How can you avoid the unfortunate outcome faced by the taxpayer in this case? The best approach is to proceed with caution. Consult a financial advisor, who is knowledgeable about retirement plans if you are considering taking an early distribution from your IRA or company plan.
Receive expert IRA and tax planning articles straight to your email. Subscribe here.
Content Citation Guidelines
Below is the required verbiage that must be added to any re-branded piece from Ed Slott and Company, LLC or IRA Help, LLC. The verbiage must be used any time you take text from a piece and put it onto your own letterhead, within your newsletter, on your website, etc. Verbiage varies based on where you’re taking the content from.
Please be advised that prior to distributing re-branded content, you must send a proof to email@example.com for approval.
For white papers/other outflow pieces:
Copyright © [year of publication], [Ed Slott and Company, LLC or IRA Help, LLC - depending on what it says on the original piece] Reprinted with permission [Ed Slott and Company, LLC or IRA Help, LLC - depending on what it says on the original piece] takes no responsibility for the current accuracy of this information.
Copyright © [year of publication], Ed Slott and Company, LLC Reprinted with permission Ed Slott and Company, LLC takes no responsibility for the current accuracy of this information.
For Slott Report articles:
Copyright © [year of article], Ed Slott and Company, LLC Reprinted from The Slott Report, [insert date of article], with permission. [Insert article URL] Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article.
Please contact Matt Smith at firstname.lastname@example.org or (516) 536-8282 with any questions.