Every year I lecture on the time value of money. Part of the lecture compares a normal taxed savings account funded with after-tax dollars to a tax-free retirement account funded with pre-tax dollars. At the end of my assumed 40-year investment period the difference astonishes the students and drives home my main point about the time value of money.
The effectiveness of my point does not depend on which type of tax-deferred retirement account is being used. I figure most of my students will make use of a traditional IRA, or Roth, or spousal, or will be able to make use of a 401(k) plan or a 408(k) SEP plan. It does not matter which type of plan they use: the power of tax deferral works in all of them.
But the type of retirement plan can make a huge difference to the treatment of early withdrawals. That is the lesson from last week’s case of Lily Hilda Soltani-Amadi and Bahman Justin Amadi v. Commissioner, T.C. Summary Opinion 2019-19 (Aug. 8, 2019) (Judge Armen). The taxpayers there had made an early withdrawal from their 401(k) plan to help buy their first home. The distribution would have been penalty-free had it come from an IRA. But it came from a 401(k) and so, while permitted, it carried with it the §72(t) 10% penalty. Details below the fold.
The Law: A Brief History of IRAs and 401(k)’s.
In 1974, Congress created the modern IRA by enacted a new §408 to the Tax Code, as part of the massive Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93–406, 88 Stat. 829. It was pretty basic but had the key features it still has today: an annual contribution limit into a qualified account, tax deferred on earnings within the account, and an 10% penalty on distributions made from the account before age 59½. That 10% penalty (and exceptions) was put into §408(f).
In 1978, Congress enabled the modern defined contribution plans by creating a new subsection (k) in §401. Revenue Act of 1978, Pub.L. 95–600, 92 Stat. 2763. You can find a nice short history of §401(k) and its unexpected consequences in this CNBC article from 2017.
In 1986 Congress created §72(t) as a kind of penalty hub for early distributions from any type of retirement plan. Tax Reform Act of 1986 P.L. 99-514, 100 Stat. 2085, 2472. It nuked §408(f) and moved the IRA early withdrawal penalty into §72(t). Id. at 2475. Section 72(t) is now the go-to place to figure out early distribution penalties for all types of retirement accounts, including 401(k) plans and the various flavors of IRAs.
Section 72(t) works like this. The general rule in §72(t)(1) is now as it first was in 1986: a 10% penalty on any distribution from “a qualified retirement plan (as defined in section 4974(c)).” The §4947(c) definition includes all types of retirement plans, including those authorized by §401(k) and 408. The penalty “is an amount equal to 10 percent of the portion of such amount which is includible in gross income.” §72(t)(1). So if no amount of the distribution has to be included in gross income, there is no penalty hit.
In addition, §72(t)(2) gives a bunch of exceptions to the 10% penalty. Some of the exceptions are for all types of “qualified retirement plans.” Others are only for “certain plans.”
For example, §72(t)(2)(A), helpfully titled “In General,” lists a bunch of exceptions that apply to all qualified retirement plans. In contrast, §72(t)(2)(E) provides an exception for distributions that are used for qualified education expenses, but only if those distributions come from “an individual retirement plan.”
Some exceptions are sneaky. For example, the exception in §72(t)(2)(C) looks like it applies to any distribution from any qualified plan (made to an alternate payee pursuant to a qualified domestic relations order). But then §72(t)(3)(A) crosses the Congressional finger and says that exception does not apply to distributions from “an individual retirement plan.” Some exceptions are off-Code. That is, Congress enacts the law but makes no corresponding change to the Tax Code. For example, §20102 of the Bipartisan Budget Act of 2018, Pub. L. 115–123, provides that §72(t) does not apply to any “qualified wildfire distribution.” But you won’t find that in §72(t).
Over the years, Congress has added exceptions to the list in §72(t). In 1997 Congress created what is now called the Roth IRA in the Taxpayer Relief Act of 1997, P.L. 105-34, 111 Stat. 787. It started in the House Bill as the “American Dream IRA” and the Senate had a companion proposal that it called the “IRA Plus.” The House and Senate members of the Conference Committee gave it the name “Roth IRA” in honor of Senator William V. Roth. See H.R. Report 105-220 (“Conf. Rep.”) at 380.
The House version of the legislation added an exception to the §72(t) 10% penalty. The exception allowed taxpayers to withdraw up to $10,000 (lifetime limit) without penalty for a qualified first time homebuyer distribution, and set up a huge number of gnarly rules to get that modest lifetime benefit.
But the House added that exception only for its new American Dream IRA. Conf. Rep. at 381. The Senate thought that exception was bully and ought to be expanded to all IRAs and not just the new Roth IRAs. Id. However, no one apparently thought to expand this new exception to all “qualified retirement plans.” So that is how it remains today, in §72(t)(2)(F). If a distribution satisfies the gnarly rules to be a first time homebuyer distribution, taxpayers escape the 10% penalty only for distributions from “individual retirement plans.” In case you needed it, those are defined in §7701(a)(37) as limited to those plans described in 408(a) or (b).
Mr. and Ms. Amadi bought a home in 2015. It was their first home. To help with their closing costs they tapped into Ms. Amadi’s 401(k) plan to the tune of $6,686. This was likely a permitted hardship distribution. See Treas. Reg. Treas. 1.401(k)-1(d)(3)(iii)(B). They neither reported the distribution as income nor did they pay the 10% tax.
They got caught and were dinged for a $1,700 deficiency. In their Tax Court petition, they said they had talked to someone in the company that managed their 401(k) and “he said since we are first time home buyers, we won’t be paying full penalty.” One then wonders why they did not at least report the amount as income, particularly when their Tax Court petition admits they knew they were supposed to do that: “I knew that we had to pay some tax on it, but not this much!” At bottom, the petition pleads “We just need a break. We have worked very hard and put ourselves through school. We could use a break.”
Judge Armen gently gives a very clear explanation of how §72(t) works and explains why the 401(k) distribution is subject to the general 10% penalty and is not part of the first time homebuyer’s exception. He writes “Although the Court found petitioners to be sincere, credible, and earnest, the fact remains that the Court is a court of limited jurisdiction and lacks general equitable powers. Thus the Court is constrained by the text of the statute and may not act contrary to it.” Those are generous words, especially when the taxpayers totally failed to report the distribution as income and yet admitted they knew they were supposed to have done so.
It’s all on Congress. Judge Armen explains: “Congress chose to grant relief...for distributions from IRAs but not for distributions from other qualified plans, such as a section 401(k) retirement plan.” I confess I am puzzled by the Congressional decisions, reflected in §71(t), to distinguish between types of retirement accounts for different exceptions. I welcome any comments explaining those distinctions. This seems just ad-hockery.
The ad-hockery creates traps for the unwary: distributions are permitted under §401 rules but then still subject to the 10% tax whose very purpose is to discourage the distributions taken. Certainly, Mr. and Ms. Amadi were unwary. But perhaps some of that was deliberate eye-shading. It certainly did not take me long to find this very helpful Wikipedia page that pretty clearly explains the law using a chart form. If they had consulted that chart they would have seen that their 401(k) distribution, while permitted, was not penalty-free. Just because taxpayers can find answers on Wikipedia, however, does not make the law any less of a trap. Taxpayers may be understandably confused when one statute says "ok!" and another says "pay!"
Congress has actually expanded the trap in the Bipartisan Budget Act of 2018, Pub. L. 115–123, 132 Stat. 64, 161. There it relaxed hardship distributions rules and and told Treasury to revise the applicable regulations to reflect an expanded notion of qualifying hardships. See Id. (§§41113, 41114). Treasury indeed issued draft regulations in December 2018. See IRB 2018-49 (December 3, 2018) at 841. You can find the latest guidance gathered on this helpful IRS Webpage. As the scope of permitted hardship distributions increases, however, more and more taxpayers will find themselves hit with an unexpected and difficult to afford tax penalty. After all, if the taxpayers are cash-strapped enough to tap into retirement savings, they are likely too cash-strapped to pay the withdrawal penalties.
Again, if Congress thinks a 401(k) distribution should be permitted because of hardship, I don't see why the distribution should be penalized under §72(t). If there is a reason for this, I again ask that someone teach all of us in the comments. Until then, while I am certainly wary, I remain clueless.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. His retirement plan is to keep teaching. Sorry Millennials!