IRA Withdrawal Subject to Tax and Penalty

IRA Withdrawal Subject to Tax and Penalty

By: Martin M. Shenkman, CPA, MBA, JD


If you’ve been struggling through this recession, a recent court case has some potentially bad news for you.  A taxpayer, Mr. Colegrove, struggling with economically tough times, tapped his IRA to get by.  The IRS determined that the withdrawals from his IRA weren’t loans, but rather taxable distributions. Ouch! The Court agreed with the IRS but couldn’t help the guy because the law just ain’t reasonable. Read on. James T. Colegrove, et ux., TC Summary Opinion 2010-44.

The moral of this sad tale is that if you need cash desperately to make ends meet, taking funds out of your IRA will be a costly last resort.

The Taxpayer’s Tale, or Sgt. Joe Friday – Just the Facts Ma’am

Mr. Colegrove worked as a real estate agent for nine months. Market pressures resulted in a drastic reduction in business, his income, and an increase in overhead and expenses. Eventually Mr. Colegrove was able to secure full-time employment in another line of work.

During the period of reduced income, Mr. Colegrove struggled to pay his business expenses, pay his home mortgage, and provide for the living expenses for a family of four. To meet those needs, Mr. Colegrove requested funds from his Individual Retirement Account (IRA). Mr. Colegrove's intent was that the funds withdrawn would be in the form of a loan and not a distribution.

He received six distributions from the IRA in the following amounts: $8,500; $2,090.61; $10,000; $10,000; $10,218; and $11,323.66. Under the “Distribution Summary” section of the Charles Schwab account statements for 2006 is an entry for “premature”. The IRA's monthly account statements for 2006 show an increase in the year-to-date premature distributions.

Mr. Colegrove filed his income tax return for the year, Form 1040, U.S. Individual Income Tax Return and did not report the $52,132.27 distribution from his IRA as income. He also did not report the 10% additional tax that is due on an early distribution of an IRA. Code Sec. 72(t). Mr. Colegrove believed the distribution was a loan from the IRA and not an early withdrawal.

The IRS had a rather different view of the matter. The IRS’ position was that the $52,132.27 distribution from the IRA is includable in income, and that poor Mr. Colegrove is liable for the 10% tax on the early distributions from an IRA. Double Ouch!


The Technical Stuff – What the Tax Law Says

Let’s get the playing field straight. Taxpayer says “day” and the IRS says “night.” The law says that the IRS notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is in error. In English, you gotta prove the IRS wrong ‘cause the Courts are going to assume that the IRS is right! See Rule 142(a); Welch v. Helvering,  290 U.S. 111, 115 [12 AFTR 1456] (1933). This concept, called the “burden of proof” gets more complicated as the responsibility to prove who is right can switch (“shift” in tax jargon), but that gets beyond our scope here.

Here’s what the law says about IRA withdrawals. Any amount paid or distributed out of an IRA must be included in your gross income by as required under Code Section 72. IRC Sec. 408(d)(1).  If you’ve tapped your IRA to get through the recession this could be your headache too.

Taxpayer argued that the distribution from his IRA was to be in the form of a loan. While that might work for a loan from a qualified employer (pension plan) its not in the IRA game book.  A loan from an IRA to its owner is always a prohibited transaction. There is no exception for loans from an IRA to its beneficiary.” 4 Patrick v. Commissioner, T.C. Memo. 1998-30 n.8, affd. without published opinion  181 F.3d 103 (6th Cir. 1999);  Sec. 4975(c)(1)(B); Employee Retirement Income Security Act of 1974, Pub. L. 93-406, Sec. 408(d), 88 Stat. 885. If such a loan were made, the IRA would lose its exemption and all assets would be deemed distributed.  Sec. 408(e)(1) and  (2); Patrick v. Commissioner, supra. That means a loan would disqualify your entire IRA and the entire IRA would be taxable even if you only borrowed a small portion!


Possible Ways to Ease the Pain

If you’re in the same leaky boat as poor Mr. Colegrove, there may be some other ways out of the tax fix (but none of these worked for Mr. Colegrove):

  • Annuity.

    If your distribution was an annuity, special exceptions to the harsh tax now rule apply. IRC Section 72(e); Vorwald v. Commissioner,  T.C. Memo. 1997-15.
  • Offset with Tax Basis.

    If you made non-deductible contributions to your IRA, a portion of any withdrawal would be considered a return of that non-deductible contribution and the tax bite would be lowered. Treas. Reg. Sec. 1.408-4(a)(2).,  You’d be given credit for any investment in your IRA from these non-deductible contributions. IRS Section 72(e)(3)(A)(ii) and (6).


Penalty Pain adds to Taxpayer’s Woes

The law imposes a 10% penalty if you take an early distribution from a qualified retirement plan if none of the special exceptions apply. IRC Section 72(t). Congress created this penalty to encourage folks to save for retirement (not much consolation when you’ve lost your job or your business is in the ringer). S. Rept. 93-383, at 134 (1973), 1974-3 C.B. (Supp.) 80, 213.

Struggling Mr. Colegrove used his IRA money to pay business and living expenses and a home mortgage. No exception applies for those purposes, so the court determined that his  distribution was not only subject to income tax, but also subject to the 10% additional tax.


Hello Folks in Washington

The Court then went on to acknowledge: “Although petitioners' financial circumstances were not unusual during this tumultuous period, the tax code is sometimes unforgiving in its attempts at standardization.” The Court (and perhaps even the IRS) really wanted to help Mr. Colegrove. The court really felt bad for this guy. Listen to what the court said next: “In closing, we think it appropriate to observe that we found petitioners to be conscientious taxpayers who take their Federal tax responsibilities seriously.” The court and the IRS couldn’t cut Mr. Colegrove any slack because the law did not permit it. Could this be ‘cause the folks in Washington have a different economic status and are not as attuned to what the average Joe or Jane goes through? Could it be that they don’t read and understand the tax rules they pass?

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