1- Understanding IRA Rollovers
Rolling over a company retirement plan distribution into an IRA is usually a good idea. It allows you to defer taxes on the rolled-over balance, and the future income earned on that balance, for as long as the money stays in the IRA. However, the IRA rollover strategy is not always a no-brainer, as one taxpayer discovered in a rollover horror story that could have been prevented with tax-smart advance planning.
But before getting to the taxpayer’s story, let’s first cover some necessary background information.
Early Withdrawal Penalty
For purposes of this article, we will call a pre-age 59 1/2 withdrawal from a qualified retirement plan account (such as a company 401(k) account) an early withdrawal. The general federal income tax rule states that the taxable portion of an early withdrawal will get hit with a 10% early withdrawal penalty — unless one of the tax-law exceptions gets you off the hook. The same general rule applies to the taxable portion of an early withdrawal from an IRA (before age 59 1/2).
Early Withdrawal Exception
For early withdrawals from a company qualified plan, there’s an exception to the 10% early withdrawal
penalty if you’ve reached age 55 and have “separated from service” when you take the withdrawal. Separation from service means permanently leaving the company for any reason.
The age-55 exception allows you to take an early withdrawal from the company plan, keep some or all of the money in your pocket instead of rolling it into your IRA, and not owe the 10% early withdrawal penalty on any of the money you choose to keep. Understand that if you do this, you will owe federal income tax (and maybe state income tax, too) on the money, but you won’t get hit with the 10% penalty. (However, you won’t owe any tax or penalty on any amount that you roll over into an IRA.)
Important: There is no age-55 exception for early IRA withdrawals. That is because the list of qualified retirement plan exceptions to the 10% early withdrawal penalty is not exactly the same as the list of IRA exceptions to the 10% early withdrawal
penalty. This may seem to make no sense, but as they say, “it is what it is.”
IRS Example
In a court decision earlier this year, one taxpayer found out the hard way that there is, in fact, no age-55 exception for early IRA withdrawals.
Case facts At the age of 56, Young Kim left his job as a partner in a law firm to attend the London School of Economics. He rolled over the balance from his law firm’s qualified retirement plan account into an IRA. The following year, he withdrew about $240,000 from the IRA and paid the resulting federal income tax liability. However, Kim did not pay the 10% early withdrawal penalty because he believed he qualified for an exception for taxpayers age 55 and older.
The IRS audited Kim’s return for the year in which he took the early IRA withdrawal. The tax agency assessed the 10% early withdrawal penalty plus an additional penalty for substantially understating his tax liability by failing to include the 10% penalty on his return. The two penalties totaled more than $24,000.
The taxpayer took his case to the U.S. Tax Court where he argued that it was not logical for the age-55 exception to be allowed for early qualified plan withdrawals but not for early IRA withdrawals. The Tax Court correctly observed that there is no requirement for the tax law to be logical. Therefore, the Tax Court concluded that Kim was indeed liable for the penalties of more than $24,000.
Next, the still-unconvinced taxpayer took his case to the Seventh Circuit Court of Appeals which, unfortunately for him, reached the same conclusion as the Tax Court.
The appeals court reiterated something that most of us have known for years — that the U.S. tax code isn’t necessarily rational. The ruling stated: “Kim insists that this makes no sense. He could have taken the money from the law firm’s pension plan without the 10% additional tax; why should it matter that the money went from the law firm’s plan to an IRA before being withdrawn? The answer is that the Internal Revenue Code says that it matters…Many parts of the tax code are compromises, and all parts reflect the need for lines that can’t be deduced from first principles…”
Tax-Smart Planning
Since Kim was older than 55 when he left his law firm job, he would have qualified for the age-55 exception to the 10% early withdrawal penalty if he had simply withdrawn the $240,000 that he needed from the firm’s retirement plan.
Then he could haven rolled over the rest of his retirement plan money into an IRA with no taxes due on the rolled-over amount. Instead, he rolled all the retirement plan money into the IRA and then took the $240,000 from the IRA. Because the IRA withdrawal occurred while he was under age 59 1/2, the 10% early withdrawal penalty applied.
Lesson Learned: While rolling all of your company retirement plan money into an IRA is generally a good idea, it is not always the most tax-smart step to take. (Young Kim, 7th Circuit Court of Appeals, 2012, No. 11-3390)
By Valerie Colin, Senior Vice President, Gumbiner Savett Inc.
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