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The Tax Blotter: February 2020

Generally, if you make a withdrawal from a traditional IRA before age 59½, you owe a 10% penalty tax in addition to your regular income tax liability. But the tax code contains a long laundry list of exceptions to this rule.

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Generally, if you make a withdrawal from a traditional IRA before age 59½, you owe a 10% penalty tax in addition to your regular income tax liability. But the tax code contains a long laundry list of exceptions to this rule.

Be tax-smart on withdrawals. As with IRAs, early withdrawals from an employer-sponsored retirement plan, like a 401(k) plan, result in a 10% penalty tax. The list of exceptions differs slightly from the one for IRAs. Case in point: A taxpayer who was employed at a government unit in Texas went back to school at age 42. She used proceeds from her government plan to pay for education expenses. The catch: The exception to the penalty tax for early distributions used to pay for education only applies to IRAs—not qualified plans (McCree, TC Memo 2019-67, 6/6/19).

A roll of the dice. There’s another exception to the 10% penalty tax in the law for IRA distributions made on account of disability. But the disability must be total and permanent. In a new case, a taxpayer had to take large doses of medication to relieve restless leg syndrome. She ended up with an uncontrollable gambling compulsion. Eventually, she withdrew over $100,000 from her IRA before age 59½ to pay for gambling activities. Unfortunately, the Tax Court said this didn’t constitute a disability because the condition was remedial (Gillette, CA-7 No. 19-1343, 1/15/20).

Giving birth to new exception. The new retirement law p[assed late last year—the Setting Every Community Up for Retirement Enhancement (SECURE) Act—adds to the list of exceptions to the 10% penalty tax for early IRA withdrawals. Under the SECURE Act, the penalty doesn’t apply to the first $5,000 used to pay for qualified birth or adoption expenses. This limit applies to all plans in which you participate, including IRAs and 401(k)s. However, the maximum is doubled to $10,000 for a married couple if each spouse separately pays $5.000 in expenses.