Kim and her husband filed their 2004 tax return in a timely manner. They reported the total amount of Kim's distributions and filed Form 5329 (Additional Taxes on Qualified Plans [Including IRAs] and Other Tax-Favored Accounts) with their return, noting that all the IRA distributions were not subject to the penalty.
In 2007, the IRS notified Kim and her husband that the additional distributions modified Kim's 72(t) payment plan. They determined that all Kim's distributions for 2004 were subject to the 10% penalty, except for the total amount paid that year for college expenses in the amount of $35,221.50. The additional tax came to $8,959.
Since Kim and the IRS did not agree on the amount of the additional tax owed, they ended up in Tax Court. In a surprising decision, the Court ruled in favor of Kim. The Court found that the wording in the tax code does not prevent the IRA owner from using more than one 10% penalty exception. Each exception will be looked at on its own.
WAIT AND SEE
In today's tough economy, more retirement plan owners are finding it necessary to tap those funds prematurely. Many are setting up 72(t) payment plans, and some are finding the plans they set up in the past no longer meet their needs.
This court decision points out some of the pitfalls of these plans. Payments are fixed for most individuals, and the consequences of modifying a plan can be severe. Even when taken properly, these payments can have a marked impact on account values, leaving clients with much less to live on in retirement. This decision, however, may give account owners some much-needed flexibility if they require more funds for higher education expenses, medical expenses or medical insurance. Those are the only three exceptions to the penalty that contain the language allowing the use of more than one exception, including a 72(t) payment plan.
While it is interesting to know how one court has ruled on this issue, until we know for sure whether the IRS will follow this court decision in future rulings, the best advice is not to modify 72(t) payment plans. Individuals should not count on this ruling to bail them out if they need extra funds; and they should not enter into 72(t) plans lightly. Before starting a 72(t) payment plan, it's a good idea to split an IRA if possible and keep the second one for emergency cash.
Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author. Slott created The IRA Leadership Program and Ed Slott's Elite IRA Advisor to help financial advisors become recognized leaders in the IRA marketplace. Visit his website at www.irahelp.com