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Taypayer Runs Afoul of Early Distribution Rule

Taypayer Runs Afoul of Early Distribution Rule

Tax Court finds withdrawals to pay alimony were subject to 10 percent income tax
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The Tax Court recently addressed whether a taxpayer must pay an additional 10 percent income tax on distributions he received from his qualified retirement plans, despite the fact that the funds were subsequently used to pay court-ordered alimony to the taxpayer’s former spouse.  In Hartley v. Commissioner, T.C. Memo 2012-311 (Nov. 6, 2012), the taxpayer had a number of qualified retirement plans, and in 2009 he received distributions from such plans totaling approximately $52,600.  He reported these funds on his 2009 federal income tax return as income from pensions and annuities.  Nonetheless, the Internal Revenue Service determined a deficiency for such year, claiming that, pursuant to Internal Revenue Code Section 72(t)(1), these withdrawals were subject to an additional 10 percent tax. 

 

IRC Section 72(t)(2) provides various exceptions to this additional 10 percent tax levied on early withdrawals from qualified retirement plans.  Specifically, the taxpayer pointed to IRC Section 72(t)(2)(c), which provides an exception for distributions from a qualified retirement plan to an “alternative payee” pursuant to a qualified domestic relations order, as provided in IRC Section 414(p).  The taxpayer claimed he had made the withdrawals to pay alimony to his former spouse.  IRC Section 414(p)(8) further defines an “alternative payee” to include any spouse, former spouse, child or other person who, pursuant to a domestic relations order, has the right to receive any portion of the benefits of a plan which are otherwise payable to the taxpayer. 

 

In rejecting the taxpayer’s argument that the distributions weren’t subject to the additional 10 percent tax, the Tax Court first noted the distributions were made not to an “alternative payee,” but rather directly to the taxpayer.  In addition, while a family court judge instructed the taxpayer in Hartley to make distributions from his retirement plans to pay alimony to his former spouse, no qualified domestic relations order was ever prepared.  Therefore, the exception provided Section 72(t)(2)(c) was inapplicable.  The taxpayer could point to no other applicable exception, so the Tax Court agreed with the IRS and held that the taxpayer was obligated to pay an additional 10 percent income tax on the distributions from his qualified retirement plans.

 

This case illustrates that the 10 percent additional tax provided in Section 72(t)(1) may cause unintended consequences if a taxpayer requests an early withdrawal from his qualified retirement plan without first considering the tax implications.  The taxpayer could have avoided this additional tax by both making sure that a qualified domestic relations order was issued and ensuring that the distributions were made directly to his former spouse.  With these two relatively simple steps, the taxpayer would have ensured that he fell into the IRC 72(t)(2)(c) exception and, therefore, would have avoided an additional $5,000 in taxes.  Therefore, while hindsight is often 20-20, taxpayers and their advisors should always keep the tax code in mind when considering making early withdrawals from qualified retirement plans.

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