Lesson From The Tax Court: Finding Safe Harbors From The §72(t) Early Distribution Penalty

Congress wants taxpayers to save for retirement.  To encourage such savings, Congress authorizes a smorgasbord of tax-advantaged retirement plans that taxpayers can use.  Authority for such plans are scattered in different statutes, such as §401, §403, and §408.  Again, the purpose of these provisions is to allow taxpayers to save for retirement.  Congress give other ways for taxpayers to defer taxation on savings for other purposes, such as post-secondary education.  See e.g. §529.

To reinforce the focus on using these accounts for retirement and not for other purposes, Congress imposes a 10% penalty—er—I mean “addition to tax” when taxpayers take distributions from qualified retirement plans too soon before retirement.  §72(t).  Yeah, §72(t) is titled “10-percent additional tax on early distributions from qualified retirement plans.”  But as I explain in the Coda at end of this post, its operative language is indistinguishable from §72(q) which is titled as a “10-percent penalty....”  So let’s just call it what it is:  a penalty for early distributions.

How soon is too soon?  Age 59½.  §72(t)(2)(A).  Any distribution made before age 59½ is deemed to be an early distribution and subject to the 10% penalty.  I have no idea who came up with 59½ as the magic line.  I welcome comments from knowledgeable readers on whether it had anything to do with budget scoring.  I think of this as the general rule, applicable to all types of retirement accounts: early distributions pay the penalty.

Over the years Congress has created rules allowing early distributions to be made without penalty, but only if they are taken for certain purposes.  I think of these rules as exceptions—safe harbors—to the general rule of 59½.

These safe harbors can be complex and we learn today that you need to be very careful when trying to navigate into one of them.  In Edward George Shilkas v. Commissioner, T.C. Summ. Op. 2024-10 (June 20, 2024) (Judge Panuthos), the taxpayer took an early distribution that may have escaped penalty if taken from the right type of account.  But the taxpayer took it from the wrong type of account.  In Caren Kohl v. Commissioner, T.C. Summ. Op. 2024-4 (Apr. 25, 2024) (Judge Siegel), the taxpayer took a distribution that may have escaped penalty if taken in the right year.  She took it in 2018 for a purpose that Congress later decided should not be subject to the 10% penalty, but the later-created safe harbor was not available in 2018. 

Details below the fold. 

Brief History of Tax-Advantaged Retirement Accounts
In 1974, Congress created the modern Individual Retirement Account (IRA) as part of the massive Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93–406, 88 Stat. 829.  The new statute, codified as §408 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.

Section 403(b) authorizes similar plans for employees of public education institutions and §501(c)(3) organizations.

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 10% 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 unchanged from 1986: taxpayers must pay 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 employer plans authorized by §401(k) and individual plans authorized by §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 it does look like there is no penalty if no amount of the distribution has to be included in gross income! 

Section 72(t)(2) then 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, the list of exceptions in §72(t)(2)(A), helpfully titled “In General,” 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,” i.e. an IRA.

Some exceptions are sneaky.  For example, the exception in §72(t)(2)(C) looks like it applies to any “distribution to an alternate payee pursuant to a qualified domestic relations order.” So that means from any type of plan, right?  Nope.  You have to keep reading because the later §72(t)(3)(A) then crosses the Congressional finger and says that exception does not apply to distributions from “an individual retirement plan.”  So that means the exception only works for distributions from 401(k) or 403(b) employer plans.  Oh Dangskies. 

Another example of a sneaky exception is the one for a qualified home purchase. 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 what became the Roth IRA.  Conf. Rep. at 381. The Senate conferees thought that exception should be expanded to all IRAs and not just the new Roth IRAs.  Id.  However, no one apparently thought to expand this new exception to the other types of “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 but only if the distributions come from “individual retirement plans.”  In case you needed it, those are defined in §7701(a)(37) and are limited to those plans described in 408(a) or (b):  IRAs.

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) itself.  The statute was never codified.

These off-Code exceptions can be like the Cheshire Cat: they appear then disappear.  The same off-Code provision in the 2018 legislation is an example of that as well.  That statute defines “qualified wildfire distributions” to mean only distributions “from an eligible retirement plan made on or after October 8, 2017, and before January 1, 2019, to an individual whose principal place of abode during any portion of the period from October 8, 2017, to December 31, 2017, is located in the California wildfire disaster area and who has sustained an economic loss by reason of the wildfires to which the declaration of such area relates.”

Well that’s great for taxpayers hit by wildfires between October and December of 2017.  But it is of no help to taxpayers hit by later wildfires, such as the Dixie fire in 2021 one of the largest single wildfires in California history.  Sure, the IRS gave procedural relief for taxpayers affected by the Dixie fire (extending filing deadlines, etc.).  And, sure, §139 gave substantive relief by allowing taxpayers to exclude various disaster relief payments from gross income. But Congress did not create any safe harbor from the 10% penalty for early distributions from retirement accounts like there was for the 2017 fires.

This IRS webpage does a great job in listing the various Cheshire Cat provisions that exclude early retirement account distributions from the 10% penalty for certain disasters, but not others.

Some exceptions are limited both in time and to specific retirement accounts.  For example, in 2022, Congress created a new exception for distributions made to cover a taxpayer’s “emergency personal expenses.”  Section 115 of the Consolidated Appropriations Act, 136 Stat. 4459, 5296 creates a new §72(t)(2)(I).  This new provision permits an early distribution of no more than $1,000 for emergency personal expenses, but only from “an applicable eligible retirement plan (as defined in subparagraph (H)(vi)(I)).”  When you bop over to cross-referenced (H)(vi)(I), however, you see that does not do anything more than cross-reference to §402(c)(8)(B)! And that provision lists the following six flavors of retirement plans:

“(i) an individual retirement account described in section 408(a), (ii) an individual retirement annuity described in section 408(b) (other than an endowment contract), (iii) a qualified trust, (iv) an annuity plan described in section 403(a), (v) an eligible deferred compensation plan  described in section 457(b) which is maintained by an eligible employer described in section 457(e)(1)(A), and (vi) an annuity contract described in section 403(b).”

I don’t know about you, but I don’t see any reference to 401(k).  That means that this emergency personal expenses exception, like the homebuyer exception, does not apply to distributions from 401(k) plans.  I welcome correction on my trip through the statutory cross-references!

Further, like the Wildfire exceptions, the emergency personal expense exception does not apply to all tax years.  The Cheshire cat starts smiling only for “distributions made after December 31, 2023.”  §115(c).  And no one can predict when this cat will disappear.

The following two cases teach us some of the difficulties in navigating the safe harbors for early distributions.  Let’s take a look.

Lesson From Shlikas: Trace To the Right Retirement Account
Mr. Shlikas and his brother jointly owned a home left to them by their mother in her Last Will & Testament.  In 2019, when he was 50 years old, Mr. Shlikas received two distributions from his TIAA-CREF retirement accounts.  He used that money to buy out his brother’s interest in the home.  One of the accounts was a 403(b) account and the other may have been an IRA.  One distribution was $46k and the other was $91k, totaling $137k.  It is not clear from the opinion which distribution came from which account.  Title transferred in December 2019 and Mr. Shlikas became sole owner.

Mr. Shlikas reported the entire $137k as income on his 2019 return.  Based on the 1099-R issued by TIAA-CREF, the IRS dinged Mr. Shlikas for the 10% penalty because he had not reached the magic 59½-year mark at the time of the distribution.

In his pro se Tax Court petition, Mr. Shlikas tried to navigate into the safe harbor of the qualified homebuyer exception in §72(t)(2)(F).  He failed because he could not show the Court what type of retirement accounts the distributions came from.  Heck, it was not even clear what type of retirement accounts he had.  In Tax Court he testified that “part of the distribution was made from a Roth IRA.”  Op. at 4.  But on his 2019 tax return he had reported the entire $137k as income which he would not have done if part of that amount had come from a Roth IRA.

Remember, it is the taxpayer’s burden to show that the Notice of Deficiency is incorrect.  So it was up to Mr. Shlikas to show the Court that his early distribution was sheltered from penalty by the qualified homebuyer safe harbor.  He could not do that.  Since he could not even show that the distribution came from a qualified retirement account, Judge Panuthos saw no need to dive into the gnarly rules of whether buying out his brother made this a qualified homebuyer distribution.

Judge Panuthos gives us the bottom line: “The record demonstrates that an early distribution was made to petitioner and he has not demonstrated that an exception applied to the imposition of the 10% additional tax...”

Lesson From Kohl: Retirement Accounts Are Not Emergency Funds
In 2018 Ms. Kohl was having trouble paying her rent.  To avoid eviction she withdrew $10,000 from her retirement account, apparently an IRA.  She did not report that amount as income on her 2018 return nor, of course, report and pay the 10% penalty.  The IRS caught the error and sent her an NOD.  She petitioned Tax Court.  Like Mr. Shlikas, she proceeded pro se.

In Tax Court Ms. Kohl understood she needed to include the distribution in gross income.  But she thought she should not have to pay a penalty as well.  She pointed to the 2022 legislation that created a new exception in §72(t)(2)(I) to the 10% penalty for distributions made to address a taxpayer’s economic hardship.

But retirement accounts are not supposed to be emergency funds.  Congress gives the tax-favored treatment so taxpayers can save for when they leave the workforce, not to deal with emergencies that arise in life.  Even though Congress created a new safe harbor for certain emergency personal expenses, the shelter is very, very shallow.  If it had applied here it would have allowed Ms. Kohl to avoid the 10% penalty on, at most, $1,000 of the $10,000 distribution she took.  So the penalty would be reduced by $100, if my math is right.  Again, Congress wants taxpayers to save for retirement and retirement accounts are not emergency funds.

Bottom Line: As with all other areas of tax, taxpayers must navigate the complex waters of retirement distribution rules carefully and stay within the lines.  When provisions seem unfair it is up to Congress and not the Tax Court to fix matters.  As Judge Panuthos notes in the Shlikas case: “The Court...lacks general equitable powers.  There is no authority in the Code or caselaw for an equitable or hardship exception to the imposition of additional tax under section 72(t) on early distributions from a retirement account.”  Op. at 4-5

Coda:  And "Addition To Tax" or A "Penalty"?
The full title of §72(t) is titled "10-percent additional tax on early distributions from qualified retirement plans"  But go look at §72(q)! It's titled "10-percent penalty for premature distributions from annuity contracts."

What on earth is the difference between subsection (q) and subsection (t)?  Well, gosh, I will let you decide for yourself.  Here's the operative language in §72(q)(1).

"(1) Imposition of penalty[.] If any taxpayer receives any amount under an annuity contract, the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income."

Now compare that to the operative language in §72(t)(1).  I dare you to find a material difference!

"(1) Imposition of additional tax[.] If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income."

I welcome comments from readers who might have a clue about why Congress gave different formal labels to what seem at least to me to be the same substantive rules!

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!  He invites readers to return on the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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