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In a recent Tax Court ruling, a taxpayer who received an early distribution from his retirement plan because he claimed he was disabled could not escape the early distribution penalty. The taxpayer received the financial hardship distribution from his retirement plan in 2005, which was before he was 59 ½ years old. Claiming he qualified for the disability exception to the 10% rule due to the mental health issues he was facing, which included post-traumatic stress and depression, following the death of a patient he had cared for.

The taxpayer claimed he should not be penalized the additional 10% tax because the distribution from his plan was approved as a “financial hardship in-service withdrawal” arising from his negative monthly cash flow. He also contended he received the distribution due to his disability.

Generally, retirement plans can only make a hardship distribution if the plan permits such distributions and there must be an immediate and heavy financial need of the employee and in an amount to meet this need. Employees will generally have to pay the 10% early distribution tax in the year of the distribution, if they are under 59 ½ years of age and they do not meet the exception to the rule. It is important to note they are not subject to mandatory 20% income tax withholding.

In this case, the Tax Court denied the taxpayer’s attempt to avoid the 10% tax based on hardship. The taxpayer could not avoid this section of the Code because it is explicit: if any taxpayer receives any amount from a qualified retirement plan, his tax is increased by an amount equal to 10% of the portion of that amount which is included in gross income – unless one of the enumerated exceptions apply. Financial hardship is not one of the exceptions. The Court also stated he would not be considered disabled for this purpose unless he was unable to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment which can expected to be of long-continued or indefinite duration.

Since the taxpayer’s physician stated his patient was expected to fully recover and his treatment did not require institutionalization or constant supervision. The taxpayer also continued working at his normal pay grade and earning the same salary as before he was diagnosed.

I wanted to republish the information on this case, as it is a good warning to anyone thinking about taking this type of early distribution from a retirement plan. I have seen many taxpayers facing a mountain of back tax debt due to taking an early distribution and not paying the tax on it when it was due. They then panic when they receive their first IRS notice stating they owe back taxes.

Many taxpayers are currently facing hardship circumstances due to the recession, unemployment, disability, etc. Please be sure to educate yourself on the circumstances under which you may take an early distribution. If you take the distribution, make sure you pay the appropriate tax on it. These types of situations can trigger a potential audit on your tax return. If your return is audited, be prepared. If you need assistance, the tax team at JK Harris stands ready to assist you in preparing for an audit, or to analyze your situation to see what we can do to help.