Failure to Take into Account Potential Future Consequences of Rollover Costs Taxpayer

In a recent decision, the Tax Court held that the taxpayer failed to qualify for an exception from the 10% additional tax applicable to an early withdrawal from a retirement account.[1] Generally, any distribution from a retirement account to the original plan participant who established the retirement account prior to the date when such plan participant has reached age 59.5 is subject to an additional 10% tax on the distribution.[2] However, there are numerous exceptions to this rule, a few of which are discussed below. In the present case, the taxpayer, Mr. Catania, argued that he qualified for the “separation from service” exception under §72(t)(2)(A)(v) which allows for a distribution to a plan participant who is at least 55, provided such plan participant has separated from service with the employer under which the plan was established. But as discussed below, the Court disagreed and held that no other exception to the 10% additional tax was applicable.

Facts

Catania worked for Home Depot and participated in the company 401(k) plan. The case does not provide any details on the length of Catania’s employment with Home Depot, but he retired in 2014. Following his retirement, he transferred his 401(k) over to an individual retirement account at Vanguard (the “IRA”). In 2016, Catania took a $37,000 distribution from the IRA. He spent the funds on home maintenance and other necessary living expenses. At the time of the 2016 distribution, Catania was 57 years old.

Vanguard sent Catania a Form 1099-R for the distribution. Catania properly reported the distribution on his 2016 federal income tax return as income but did not include the additional 10% tax on the distribution as an early withdrawal. Upon review of Mr. Catania’s return, the IRS concluded that Catania was liable for the 10% additional tax on the 2016 distribution since he had not yet attained the age of 59.5. Accordingly, the IRS issued a notice of deficiency for $3,700. Catania timely filed a petition with the Tax Court contesting the additional 10% tax on the distribution.

Analysis

The Court began its opinion citing to the general rule under Tax Court Rule 142(a) and Welch v. Helvering which states the IRS determination of a taxpayer’s deficiency is presumed to be correct, and the burden to prove otherwise lies on the taxpayer.[3] As such, the burden of proof generally lies on the taxpayer in Tax Court as was the case for Catania.

Except in the case of a Roth IRA, distributions from retirement accounts are generally taxable as ordinary income. §72(t)(1) imposes an additional 10% tax on any distribution from a retirement account that is not subject to a specific exception. The additional 10% is a tax, not a penalty, addition to tax, or additional amount as those terms are used in §7491(c), and thus the burden of proof remains on the taxpayer.[4]

The primary exception relied upon by taxpayers is that the plan participant has reached age 59.5 at the time of the distribution.[5] In general, any distribution made to a plan participant who has not reached age 59.5 is called an early distribution, hence the terminology used in calling the additional 10% tax a tax on an early distribution. There are quite a few exceptions to this 10% additional tax on early distributions, too many to list here, but some of the more commonly applicable exceptions include:

  1. Distributions to a beneficiary (or estate) on or after the death of the plan participant;[6]
  2. Distributions attributable to the plan participant being disabled;[7]
  3. Distributions made as a series of substantially equal payments made over the plan participant’s life or joint lives of the plan participant and his or her spouse, i.e., an annuity;[8] and
  4. Distributions made to an employee after separation from service after attainment of age 55.[9]

It was the last exception listed that Catania relied upon in his primary argument. Since he left Home Depot in 2014 and was 57 at the time of the distribution, he argued that he met the “separation from service” exception and thus the 10% additional tax should not apply. However, as the Court noted, §72(t)(3)(A) specifically states the “separated from service” exception does not apply to distributions from an individual retirement account, and thus was not applicable to the distribution from the IRA.[10] Had Catania not transferred his funds from his Home Depot 401(k) to the IRA, the “separation from service” exception likely would have applied, but the Court was unable to allow it in Catania’s case since such was specifically prohibited by §72(t)(3)(A).

Catania admitted that there were not other exceptions under §72(t) that might be applicable to his case but plead to the Court to allow him an exception anyway since he used the funds for home maintenance and to pay living expenses. However, as the Court noted, there is no equitable or hardship exception to the 10% early withdrawal tax.[11] Judge Vasquez, writing for the Court, noted his sympathies to Catania’s case, but nevertheless, the Tax Court is not a court of equity, but rather one of law, and thus cannot ignore the law to come to an equitable result.[12] As such, and with no statutory exceptions applying to Catania’s case, the Court had no choice but to rule in the IRS’s favor and hold Catania liable for the additional 10% tax on the 2016 distribution.

Conclusion

Unfortunately for Catania, there is a distinct difference in taking a distribution from a company 401(k) and an individual retirement account when it comes to the “separation from service” exception. Since distributions from an individual retirement account are specifically excluded from the “separation from service” exception, Catania was dead in the water with his argument. Had he anticipated needing his retirement funds prior to reaching age 59.5, or alternatively, sought some advice as to the consequences of transferring his retirement funds from the 401(k) to the IRA, the case may have turned out differently.

Take Away

This case serves as a good reminder to always think through the consequences of an action such as an early withdrawal from a retirement account or moving funds from one account to another, both the immediate consequences and future consequences. While the action may not have immediate tax consequences, it may preclude the taxpayer from taking advantage of a tax benefit or exclusion in the future. Such was the case for Mr. Catania, and had he never moved the funds from his 401(k), he could have taken the distribution in 2016 without incurring the additional 10% early withdrawal tax.

While the present case involves retirement account law, the lessons learned from this case apply across a broad spectrum of practice areas from business planning and structuring to estate planning. Taxpayers would do well in not just planning for the present but also looking to the future and accounting for future consequences that may not be on the radar immediately.

[1] Catania v. Commissioner, T.C. Memo 2021-33.

[2] §72(t)(2)(A)(i).

[3] 290 U.S. 111 (1933).

[4] El v. Commissioner, 144 T.C. 140 (2015); Grajales v. Commissioner, 156 T.C. No. 3 (2021).

[5] §72(t)(2)(A)(i).

[6] §72(t)(2)(A)(ii).

[7] §72(t)(2)(A)(iii).

[8] §72(t)(2)(A)(iv).

[9] §72(t)(2)(A)(v).

[10] See Also Emerson v. Commissioner, T.C. Memo 2000-137.

[11] Arnold v. Commissioner, 111 T.C. 250 (1998).

[12] Commissioner v. McCoy, 484 U.S. 3 (1987).