FROM THE EMAILBAG - USING A PREMATURE PENSION WITHDRAWAL TO PAY FOR HOME IMPROVEMENTS

I recently received the following email –

“I moved to Georgia with my wife and daughter and we recently purchased a home! I am planning on rolling over some money from a 401(k) account to my government retirement account. When I do this, I wanted to withdraw some to go into some home projects. I know when I had to do this before you suggested I withhold certain percentages for tax purposes. How much should I have them withhold?”

Here is my response -

“Good luck in your new home in Georgia.

A premature withdrawal/distribution from an employer pension plan is the most expensive, and probably the worst, source of funds.  I do not recommend doing this.

1. You will pay a 10% premature withdrawal penalty.

2. You will pay 22%-24% in federal income tax, depending on your level of income.  {based on my knowledge of the taxpayers' level of income}

3. You will most likely also pay Georgia state income tax (I have absolutely no knowledge of GA state income tax).

You will pay up to at least 40% of the amount withdrawn in tax and penalties.  Only 60% of what you take will remain in your pocket.

It is “more better” to take a loan from an employer account, if the plan allows for loans, than to take an actual withdrawal.

It is also better to use home equity debt if available, which may be deductible if the money is used to “substantially improve” your home.  This is perhaps the cheapest alternative.

Personal loan interest is higher than home equity debt, and not deductible, but it is still cheaper than taking money from an employer pension plan like a 401(k).

If you MUST use a distribution from your employer plan I would have at least 30% withheld for federal income tax and an appropriate amount withheld for GA state income tax, based on your GA marginal tax rate.”

Hey, fellow tax pros – do you agree with my answer?

TTFN

WHAT THE IRS SHOULD DO

In reaction/response to the COVID-19 pandemic the Internal Revenue totally closed down all operations and offices for many months in 2020.  During this period, the IRS did not process tax returns – current and amended – and did not process taxpayer and tax professional correspondence.  I do not know the extent to which payments made during this period were acknowledged and processed.
 
The “correctness” of the extent and duration of the IRS closure is open to interpretation.  But it happened and we must now deal with the consequences. 
 
When the IRS finally opened up again its system continued to spew out automatic intimidating balance due notices based on the information in the system prior to the closure.  However, much of the backlog of unopened and unprocessed correspondence were responses by taxpayers and tax professionals to erroneous balance due assessments, explaining the IRS error or correcting a taxpayer error.
 
Taxpayers in general are truly intimidated by continual, however erroneous, IRS notices.  And they will pay the requested balance due although they know the amount requested being wrong.  Many taxpayers paid the IRS what it asked for, despite having previously written, or had their tax professional write, to the IRS to explain errors in the assessment.
 
The IRS has acknowledged the backlog of returns and correspondence.  But it continues to automatically issue balance due notices, regardless of the fact that it is aware that the taxpayer may have previously responded to the notice providing information and documentation.  These continued notices assume the taxpayer had totally ignored all previous notices, which is often not true.
 
Responses to the continued erroneous mailings create more correspondence and increase the already humongous backlog.  And taxpayer erroneous overpayment of incorrect assessments must be addressed by taxpayers and tax pros, creating more correspondence to add to the pile.  This only compounds the problem.
 
What the IRS should have done, and should do now, is put a temporary hold on all open balance due accounts and cease from sending out automatic notices and other collection activities for these accounts until the backlog of correspondence is processed.  As correspondence regarding a taxpayer notice is acknowledged in the IRS system the hold must be continued until the issue is resolved.
 
Tax professional membership organizations should join together to urge the IRS to do this now.
 
TTFN

A COSTLY MISTAKE

Tax Court Summary Opinion 2019-19 deals with a mistake I have seen taxpayers, including a couple of clients, make over the years.  And it emphasizes the importance of three points –

* A little knowledge is dangerous

* Always check with your tax professional before making a move that could affect your taxes.  And

* What I have continually said is the best advice I can give any taxpayer - do not accept tax advice from anyone other than a professional tax preparer.

Here are the facts of the case.

If you take a withdrawal from an IRA account or a qualified retirement plan, such as a 401(k), prior to turning age 59½, and the withdrawal is not rolled over to another retirement account within 60 days, you are subject to a 10% premature withdrawal penalty.

The taxpayer in the case, under age 55, closed out her 401(k) plan account to make the down payment for her and her husband’s first home.  She was told by her plan representative that she would not pay a premature withdrawal penalty on the full amount because they were first-time home buyers.  But she did not verify this with a tax professional.

The IRS correctly assessed a 10% penalty on the entire amount of the withdrawal, which was upheld in TC Summary Opinion 2019-19

The taxpayer and her 401(k) representative were correct that there is an exception to the 10% penalty – Exception 09 – for a distribution of up to $10,000 for first-time home purchases (the little knowledge).  However, this exception is ONLY for distributions from an IRA account and does NOT apply to withdrawals from a qualified employer retirement plan like a 401(k).

Of the various available exceptions to the premature withdrawal penalty some are for withdrawals from ANY qualified retirement account, some are only for withdrawals from an IRA account or IRA annuity, and one is only for withdrawals only from a qualified employer retirement plan like a 401(k).  The first-time home purchase exception is one of those that applies only to IRA withdrawals.

If the taxpayer had checked what she was told by her plan representative with her, or a, tax professional before closing out the account she would have been told that none of the withdrawal would qualify for the penalty exception.

The tax professional would probably have told her to rollover her 401(k) account directly into an IRA account and then withdraw the money from that IRA account to cover the down payment.  Then $10,000 would be exempt from the penalty and the taxpayers would have saved $1,000 plus the resulting penalty and interest assessment as well as the applicable court costs.

Don’t make the same mistake, or a similar one.  Always check with a qualified tax professional before taking any action, regardless of what anyone else has told you or what you have read somewhere.

TTFN

RELIEF FOR TAXPAYERS WHO WERE VICTIM OF THE IRS WITHHOLDING FU

The big tax news of the week is “IRS axes estimated tax penalties for 400,000 taxpayers”, as Michael Cohn reported at TAXPRO TODAY.

The announcement was made in IR-2019-144.

In his article Michael explains (highlights are mine) -

“Earlier this year, in response to complaints from taxpayers who discovered they hadn’t withheld enough from their paychecks last year after passage of the 2017 tax overhaul and ended up with high tax bills, the IRS lowered the usual 90 percent penalty threshold to 80 percent to help taxpayers whose withholding and estimated tax payments fell short of their total 2018 tax liability. The agency also removed the requirement that estimated tax payments be made in four equal installments, as long as they were all made by Jan. 15, 2019.  The 90 percent threshold was initially lowered to 85 percent on Jan 16 and, after further complaints from lawmakers, it was lowered once more to 80 percent on March 22.

The IRS said it would apply the waiver automatically to the tax accounts of all eligible taxpayers, so there’s no need to contact the IRS to apply for or request the waiver. The automatic waiver will be given to any individual taxpayer who has paid at least 80 percent of their total tax liability through federal income tax withholding or quarterly estimated tax payments but didn’t claim the special waiver available to them when they filed their 2018 return earlier this year.”

Previous to this announcement, despite the changes to the policy for calculating the penalty for underpayment of estimated taxes, the IRS had been sending out notices to taxpayers assessing the penalty based on the previous 90% threshold and equal quarterly payment requirement.  The IRS has said that any taxpayer who had paid the erroneously calculated penalty will receive a refund check for the overpayment in a few months.  

Michael also explains –

“For those taxpayers who haven’t filed their 2018 taxes yet, such as those who asked for an extension until Oct. 15, the IRS is urging every eligible taxpayer to claim the waiver on their tax return when they do file.”

The way to claim the waiver on a manually prepared return is by attaching IRS Form 2210 to the tax return.

This announcement reminds us that you should never automatically pay any penalty or balance due notice you have received from the IRS or a state tax agency.  In my experience over half, more like 2/3, of all such notices are wrong. 

Whenever you receive any correspondence about a tax return give it to your tax professional immediately.  If you “self-prepared” the return, manually or using a “box”, read the notice carefully and verify the calculation of any penalty.  Better yet, consult a tax professional.

TTFN

DON'T DO IT!

Many first-time home-buyers take a distribution from their company’s 401(k) retirement plan to help fund the down payment for the purchase of the home.  And, unfortunately, they tell their tax professional about it AFTER it has been done.

This is a bad idea.  The distribution is included in the federal and probably also state taxable income of the taxpayer – at a cost of 25% to perhaps as much as 40% of the distribution.  In addition, if the taxpayer is under age 59½ he or she must pay an additional 10% penalty for early withdrawal – bringing the cost of the distribution up to as much as 50%.  So, a distribution of $20,000 only puts $10,000 to $13,000 in the taxpayer’s pocket.

The overall tax and other financial benefits of home ownership may eventually outweigh the tax cost of a 401(k) withdrawal, but I still say this is still not a good idea.

If there is no other source of funds for the down payment consider taking a loan from the 401(k) plan, if allowable, instead of an outright distribution.  The interest rate on 401(k) loans is usually low, and you are actually probably paying the interest to yourself.  This loan must eventually be paid back, or the outstanding balance will be treated as a distribution when employment with the company ends.  FYI, the interest charged on the 401(k) loan is NOT deductible on Schedule A.

One way to avoid the 10% premature withdrawal penalty when a loan from the plan is not an option is to rollover a 401(k) distribution of up to $10,000 into an IRA account and then take a $10,000 distribution from the IRA account.  Or just take $10,000 from an existing IRA account instead of the 401(k) plan.  One of the exceptions to the 10% penalty for premature withdrawals from an IRA account is a distribution for first-time purchases.  A purchase qualifies as “first time” if the taxpayer did not own a home in the two years prior to the withdrawal.  This exception DOES NOT apply to premature withdrawals from a qualified plan such as a 401(k).

So, if you are thinking about buying a home your 401(k) plan should be the last place you turn to for funding the down payment.  And you should discuss it with your tax professional BEFORE you do anything.

TTFN

THE IRS WITHHOLDING FU PENALTY FU

According to IRS Topic 306 –

“If you didn't pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.”

In February of 2018 the IRS revised the federal income tax withholding tables to reflect the lower rates enacted by the GOP Tax Act.  However, as many taxpayers found to their shock when preparing their 2018 Form 1040, withholding was reduced too “liberally” – perhaps on purpose so taxpayers would think that the Act reduced their taxes more than it actually did.  The result was that many taxpayers received substantially reduced refunds than they had in the past or had substantially increased balances due to the IRS with the filing of their returns – even if their income and withholding status and allowances did not change.

As I said back in April in my post “That Was The Tax Season That Was – Part Two” -

“Taxpayers did benefit from the lower rates of the Act, but the perhaps $50 per week more in their paycheck was usually more than the actual perhaps $25 tax savings.  The additional $25 or more per week had to be paid back when filing their 2018 return.

In addition, since the Act did away with the deduction for personal exemptions as well as many itemized deductions, the concept of the withholding exemption no longer applied.  Individuals who claimed additional exemptions for a spouse or dependents or for excess itemized deductions and did not revise their withholding for 2018 were royally screwed.  The increased amount and availability of the Child Tax Credit for dependent children under age 17 helped in some cases – but often not enough.

Almost every taxpayer whose withholding was based on the federal tables – and not a flat amount as with most IRA withdrawals and Social Security benefits – was under-withheld.  This was especially disastrous with multiple sources of withholding – like two-income couples, taxpayers with more than one job, and those receiving both pension and W-2 income.  I had clients owing $4,000, $9,000 and $20,000 because of the IRS withholding FU.”

The IRS realized its FU and thankfully, via IR-2019-55 issued on March 22, 2019, somewhat “relaxed” the safe-harbor for avoiding the penalty for underpayment of taxes - going from 90% of current year liability to 80%. 

Recently two of my clients received notices from the IRS assessing a penalty for underpayment of estimated tax using the old 90% of current liability threshold instead of the correct 80% to calculate the penalty.  These penalty assessments are clearly wrong.

I have no idea why the IRS has not made an adjustment to its penalty assessment software program to reflect the change to 80% for 2018 returns.  The Service has also not changed the 2018 Form 2210 to reflect this change.

If you receive a CP 14 or other notice from the IRS assessing a penalty for underpayment of estimated tax for 2018 DO NOT PAY THE ASSESSMENT. 

First check the math on the return, shown on Page 3 of the notice, to verify that the assessment was erroneously based on 90% of the current tax liability.  Then call or write to the IRS to explain their FU, referencing IR-2019-55.  If you write don’t expect a prompt response from “Sam”.  It will probably take 3 months before the issue is resolved.

Better yet – as soon as you receive ANY notice from the IRS or a state tax agency GIVE IT TO YOUR, OR A, TAX PROFESSIONAL IMMEDIATELY.   

You may also be able to further reduce the penalty by submitting IRS Form 2210 to “annualize” your 2018 income.  Another reason to give the notice to your, or a, tax professional – he or she will be able to let you know if this might work for you and properly prepare the Form 2210 for you. 

TTFN

DO NOTHING TILL YOU HEAR FROM ME

Good advice from Duke Ellington – especially for my 1040 clients when it comes to notices from the IRS or a state tax authority.

If you receive a balance due notice from the IRS or a state tax agency DO NOT AUTOMATICALLY PAY THE AMOUNT REQUESTED!

In my 40+ years of preparing tax returns I have found that more often than not (actually in my experience it is more like 75% of the time) a balance due notice from “Sam” or your state is wrong.  And, again in my experience, notices from a state tax agency (at least when it comes to NJ and NY) are wrong more than ones from the IRS.

If you receive a balance due notice from any tax agency immediately mail, email, or give it to the tax professional who prepared the return, or your current tax professional if you have changed preparers since filing the return in question.  If you “self-prepared” the return, perhaps relying on a “box”, seek out a tax professional for advice.  You can start your search at FIND A TAX PROFESIONAL.

And DO NOTHING TILL YOU HEAR FROM YOUR TAX PRO.

Even if the notice is correct, if it includes a penalty assessment for late payment, late filing, or underpayment of estimated taxes your tax professional may be able to get the penalty completely or partially abated using the federal First Time Abatement program, reasonable cause, or annualizing your income for estimated tax purposes.

And – very, very, very important – when sending the notice to your tax professional DO NOT SAY TO HIM OR HER, “HEY, YOU MADE A MISTAKE ON MY RETURN.”!

TTFN

WHY SHOULD A TAXPAYER HAVE TO PAY ME A FEE TO ASSESS THEM AN IRS PENALTY?

One of the sessions at the recent National Association of Tax Professionals’ Tax Forum and Expo that I attended reminded me that the potential “shared responsibility” penalty has been doubled for 2015 – going from 1% of annual household income to 2% of annual household income.  This brings up an issue I have with the “self-assessment” of this penalty.

The facts and circumstances associated with a tax return might indicate that the taxpayer(s) may be subject to a penalty for underpayment of estimated taxes.  But as a tax preparer I will not, nor am I required to, calculate the penalty and include it in the filing of the return.  If the IRS wants to assess my client(s) a penalty for underpayment of estimated tax they are welcome to do so.  If they do I will attempt to reduce the penalty assessment via one of the exceptions available on Form 2210.

Preparing a Form 2210 “upfront” involves additional work and an additional fee.  Why should a taxpayer pay me a fee to assess a tax penalty?  If a penalty is assessed by the IRS, which it may not be, then it is appropriate for me to charge the client(s) a fee to reduce or eliminate the penalty assessment.

Would the same logic not also apply to the shared responsibility penalty?  If the IRS wants to assess a taxpayer a penalty for not having full-year minimum essential health insurance coverage then they are welcome to do so, at which point I will attempt to reduce the penalty assessment using one of the exceptions for a fee.  But, as with underpayment of estimated taxes, why should the taxpayer(s) have to pay me a fee to be assessed a penalty? 

To be honest, I do calculate any penalty for premature withdrawal from a pension account on Form 5329 as part of the filing of a client’s return, but I believe this is somewhat different.  The penalty assessment is automatic and straight forward and is simple to calculate.

So fellow tax professionals, what do you have to say about my issue with the shared responsibility penalty?

TTFN

AN ETHICAL, AND PERHAPS LEGAL, DILEMMA

Recently I have been pondering an ethical, or perhaps even a legal, question.

Under Obamacare, beginning with tax year 2014 a person or family that does not have proper health insurance coverage is subject to a penalty.  The penalty is not easy to determine – such as $100 per person for the year.  The process of calculating the penalty is truly a convoluted mucking fess.

In “How to Calculate Obamacare Penalties” the tax blogosphere’s MILWAUKEE CPA tries to explain the process.  He follows his attempt at an explanation with the following statement –

“I think there are plenty of American taxpayers not to mention tax professionals, whose heads are spinning at the language, definitions and complications of deciphering the formulas. And obviously more than one formula must be used. In fact, the calculations have to be run three times. Using the term ‘greater than’ and ‘less than’ indicates a comparison and therefore requires the use of more than one formula to determine the correct answer.”

As a tax professional, having to calculate this Obamacare penalty will be a real pain in the arse, and a total waste of valuable tax season time. 

And, if I am to determine whether a taxpayer is subject to this penalty, I will, next tax season (in 2015), appear to have the added responsibility of verifying that a client has, or doesn’t have, appropriate health insurance coverage.  Another total waste of valuable tax season time.

As happened with the IRS’ excessive due diligence requirements for claiming an Earned Income Credit, the tax preparer is once again unnecessarily forced to also be a social worker.

Let’s be honest.  Whether or not a client has health insurance coverage really has absolutely nothing to do with preparing the 1040, other than that the idiots in Congress, who passed Obamacare without actually reading the Act, have made the payment of this complicated and ridiculous non-tax penalty an addition to one’s federal tax liability.

I do not want to have to ask my clients if they have health insurance coverage and determine if the coverage is adequate under Obamacare.  And I do not want to have to tell a client that the fee for his or her 1040 has increased because I had to waste time calculating his Obamacare penalty.

With the Earned Income Credit a client making a claim must pay more to have his or her tax return prepared – but he or she gets an additional refund, or pays less, because of the EIC.  With the Obamacare penalty the client is paying me a higher fee to charge him or her a penalty!  Hey, I can’t submit the bill for the additional time involved to BO. 

 

So where is the ethical or legal dilemma? 

 Whenever I prepare an income tax return with a balance due I do not automatically check to see if the client is subject to a penalty for underpayment of estimated taxes.  If the IRS wants to charge the client this penalty let them do it themselves.  If a client receives an IRS notice assessing a penalty for underpayment of estimated tax I will verify the IRS calculation and attempt to eliminate or reduce it via First-Time Penalty Abatement or by using one of the exception methods available on Form 2210.  But I will never assess a client a tax penalty “upfront” - I leave it to the IRS.

If this situation applied to my own tax return I would never “self-assess” an underpayment penalty up front.  If the IRS wants to charge me a penalty let them do it and I will proceed from there.

My question –

Beginning with the 2014 Form 1040, am I legally, or ethically, required to assess my client a penalty for not having health insurance coverage?  Or can I, as I do with the penalty for underpayment of estimated tax, ignore the issue and leave it to the IRS to determine if a penalty is appropriate?  Will I face a potential preparer penalty if I ignore the issue?

I openly solicit the opinions of fellow tax bloggers and fellow tax preparers.

TTFN

A YEAR-END TAX PLANNING RERUN - AVOIDING AN UNDERPAYMENT PENALTY

{Here is a “rerun” of a post on a year-end tax planning technique to avoid being victim of the penalty for underpayment of estimated tax.)

The Internal Revenue Service wants you to have 90% of your current year’s tax liability, or either 100% or 110% of the prior year’s tax liability (depending on the amount of your prior year’s Adjusted Gross Income), paid in during the year via withholding or quarterly estimated tax payments.  If you owe too much when your file your 1040 you could be hit with a penalty for “underpayment of estimated tax”.

There is a special year-end strategy you can use to avoid such a penalty.

First some background:

Timing is important when it comes to paying your taxes.  The underpayment penalty is calculated based on quarterly payments.

Withholding is assumed to be made evenly throughout the year.  Even if you have all your federal income tax withheld in December it is treated as being paid in equally over the 4 quarters for purposes of determining underpayment.  If you had $10,000 withheld in December it is assumed that $2,500 was paid in for each of the 4 quarters.

Estimated taxes are applied in the calculation when actually paid. If you discover you need to pay $10,000 in estimated tax for the year and you make the payment in December you will still be penalized for underpayment for the first 3 quarters.

There is an exception.  If the reason you will owe the additional $10,000 is because you sold a vacation home in November for a substantial gain you can make the payment as late as mid-January and avoid the penalty by "annualizing” your income.

Now for the strategy:

Suppose in the course of preparing your "preliminary" 2012 tax return you discover you did not have enough federal income tax withheld from your paycheck and you will owe Uncle Sam at least another $10,000 because of additional income received at various times during the year.  Instead of making a 4th quarter estimated tax payment, and risking a penalty for underpayment of estimated taxes, you can –

(1)  Take a $10,000 distribution from an IRA in December and elect to have 100% of the distribution ($10,000) withheld for federal income taxes, and

(2)  Within 60 days deposit $10,000 to another IRA, or back into the same IRA (you shouldn't wait the full 60 days – do the rollover ASAP). Make sure that you rollover the $10,000 on time - or else you will be hit with additional tax and another, more expensive, penalty!

Because federal income tax withholding, from whatever source, is assumed to be made evenly throughout the year, regardless of the date of the actual withholding, your $10,000 will be treated as 4 equal quarterly payments of $2,500 and you will avoid the penalty for underpayment of estimated tax.

This strategy may also work for state income tax underwithholding.

TTFN

AVOIDING THE PENALTY ON A PREMATURE IRA WITHDRAWAL

Here is a real life tax tale – taken from the GD extensions.

I have this couple (the husband was originally a client of my mentor Jim Gill from back in my early days who left and returned to me years later as a “lost lamb”) – the husband is in his early 70s and the wife is 20 years younger.

2009 was a bad year for the couple. The husband had a stoke and the wife lost her job. It was thought that the husband would need to go into a nursing home, but as it turns out he, thankfully, apparently recovered much better than originally expected.

The wife was told that before the husband could be covered under Medicaid for his nursing home expenses she would have to close out and exhaust her pension monies. She took a partial distribution in 2009 and again in 2010 to cover medical and living expenses.

Because the wife was under age 59½% (actually under age 55) the 1099-Rs she received in 2009 and 2010 reported the withdrawal as Code 1 – a premature distribution subject to the 10% penalty. However I was able to avoid the penalty for both years.

While the purpose of the distributions was the disability of the husband it appears to me that the exception for disability would not apply – as the monies came from the wife’s rollover IRA account.

IRS Publication 590 (Individual Retirement Arrangements) states (highlights are mine) –

“If you become disabled before you reach age 59½, any distributions from your traditional IRA because of your disability are not subject to the 10% additional tax.

You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.”

But there were other exceptions available to the wife.

For 2009 I used a combination of 2 exceptions to avoid the penalty.

The wife, having lost her job, was able to take advantage of health insurance coverage under COBRA. Pub 590 tells us that –

“. . . you may not have to pay the 10% additional tax on distributions during the year that are not more than the amount you paid during the year for medical insurance for yourself, your spouse, and your dependents. You will not have to pay the tax on these amounts if all of the following conditions apply.

· You lost your job.
· You received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job.
· You receive the distributions during either the year you received the unemployment compensation or the following year.
· You receive the distributions no later than 60 days after you have been reemployed.”

In 2009 the wife lost her job and received about $20,000 in unemployment.

The amount of COBRA insurance paid did not cover the entire distribution for 2009, so I also used the exception for “qualified higher education expenses”. The couple’s son, claimed as a dependent, was an undergraduate college student in 2009.

Pub 590 explains –

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

The IRA distribution did not have to actually be used to pay the education expenses. There is no “tracking” requirement like the one for classifying interest payments.

“When determining the amount of the distribution that is not subject to the 10% additional tax, include qualified higher education expenses paid with any of the following funds.

· Payment for services, such as wages.
· A loan.
· A gift.
· An inheritance given to either the student or the individual making the withdrawal.
· A withdrawal from personal savings (including savings from a qualified tuition program).”

So the tuition and fees could have been paid using a student loan and not the IRA distribution and the exception would still apply.

Between the health insurance paid and the qualified higher education expenses I was able to wipe out the entire penalty.

For the 2010 distribution I used the qualified higher education expenses exception again – this time for college tuition, fees and costs paid for the daughter. And I also used the exception for “unreimbursed medical expenses”.

“Even if you are under age 59½, you do not have to pay the 10% additional tax on distributions that are not more than:

· The amount you paid for unreimbursed medical expenses during the year of the distribution, minus
· 7.5% of your adjusted gross income . . . for the year of the distribution.”

For 2010 the couple’s deductible medical expenses were well in excess of 7½% of their AGI, and were claimed as an itemized deduction. This exception did not apply for tax year 2009.

Once again I was able to wipe out the entire penalty.

While I have always told my clients that the last place you should go to if you need money for any reason, especially if you are under age 59½, is a retirement account – because you could end up paying 40% or more of the distribution in federal and state taxes and penalties – when there is no way to avoid it you may be able to reduce the cost by using one of the exceptions.

FYI, here is the complete list of exceptions to the 10% penalty for early withdrawal from a “traditional” IRA –

· You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
· The distributions are not more than the cost of your medical insurance.
· You are disabled.
· You are the beneficiary of a deceased IRA owner.
· You are receiving distributions in the form of an annuity.
· The distributions are not more than your qualified higher education expenses.
· You use the distributions to buy, build, or rebuild a first home.
· The distribution is due to an IRS levy of the qualified plan.
· The distribution is a qualified reservist distribution.

All of the exceptions are discussed in detail in Publication 590.

TTFN

WHAT HAPPENS IF YOU DO NOT FILE YOUR FEDERAL INCOME TAX RETURN

It is very important that you file your federal income tax return on time – by the original April 15th deadline or by October 15th if extended – whether or not you can afford to pay all or any of any tax due. There are several reasons.

First of all it is the law.

Second, filing a tax return starts the clock running on the statutory three (3) years that the IRS has to audit the return. The IRS has three (3) years from the due date of a return – again April 15 if filed on time or October 15 if extended – or the date the return was actually filed, whichever is later, to audit the tax return. If you file your return after October 15th the clock does not start until the return is filed.

And perhaps most important, the monthly penalty rate for “filing late” with a balance due is ten times as much as that for “paying late”.

I should point out that if “Sam” owes you money there is absolutely no penalty for filing your Form 1040, or 1040A, late. You can file a 2007 tax return in January 2009 and not be penalized if you are getting a refund. However, the three year clock will not begin running until January 2009.

This year there was a special reason to file your 2007 federal income tax return on time. An economic “stimulus” election year bribe check will not be mailed to you this year, if you qualify for one, if your federal income tax return was not filed by October 15, 2008.

Granted if you do not receive a check in 2008, based on 2007 information, and the rebate was not used to offset outstanding federal or state tax liabilities, all is not lost. You can claim the rebate, based on 2008 information, as a refundable credit on the 2008 tax return. However, if your situation changed in 2008 such that the amount of the rebate to which you are entitled is reduced you could be a loser. If you had a dependent child who was under age 17 in 2007 you would be entitled to an additional $300.00. But if that child turned age 17 in 2008, and you did not file your 2007 return on time and therefore did not get a rebate check, you would lose the $300.00.

On the other hand, a taxpayer who would not have received a rebate check in 2008 based on a timely filed 2007 return because the money was withheld to offset outstanding prior year income tax debt can hold off mailing his/her 2007 Form 1040 to “Sam” until January 2009 and it is believed that he/she will be able to claim the rebate amount as a credit on the 2008 return.

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Over the past 35+ years I have come across quite a few clients who did not file on time. Often I have prepared two consecutive years' 1040s at the same time.

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If three or four years pass since the due date of a return and it is still not filed there is an excellent chance that the Internal Revenue Service will reconstruct the return for you, using the information it has available in its computer “matching” system. Of course this will only happen if your have income that is reported to the IRS by a third party – such as W-2 wages, gross pension and annuity distributions, interest, dividends, gross proceeds from the sale of assets, and income “passed-through” on a Form K-1.

Why would this happen? I have encountered two reasons.

One is that the first and second return is not filed on time because of ill health – physical or mental (this could include an addiction to alcohol or drugs). When it comes time to prepare the third year’s return the taxpayer is already two years behind, and things just begin to snowball.

Another reason is that a taxpayer just stops filing tax returns because of the misconception that he/she no longer has to file tax returns. For some unknown reason there are those who think that you do not have to file tax returns any more once you reach age 65 or age 72. This is bull-pucky (technical IRS term). You are required to file a federal income tax return from the day you are born until the day you die, whether you go to your final audit at age 66 or 96, as long as you have sufficient net taxable income!

The problem with the IRS “reconstructing” a tax return is that they prepare the return in the worst possible way.

If you are married they will calculate the tax as Married Filing Separately – reconstructing two returns if there is income reported under both spouse’s Social Security numbers. If you should be filing as Head of Household the IRS will classify you as Single.

You will not be given any exemptions for dependents, even if you had claimed dependents in the past. The only personal exemption that will be included in the calculation is that for yourself, which may be reduced due to a truly “gross” AGI. If there are no dependents there will be no corresponding Child Tax Credit.

The gross amount of income that is in the IRS computer system under your Social Security number will be included in AGI.

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* If you were issued a Form 1099-R for $50,000 for a distribution from an employer pension plan or an IRA that was rolled over within the 60-day “grace” period, and therefore not taxable, the full $50,000 will be included in AGI, and you will be assessed the 10% premature withdrawal penalty.

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* There will be no provision for the cost basis of any asset sales reported on a Form 1099-B – 100% of the gross proceeds will be included in income and taxed as short-term gains.

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* No deductions will be taken against business income reported as “non-employee compensation” on a Form 1099-MISC, and self-employment tax will be calculated on the full amount.

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* There will be no “above the line” deductions (i.e. qualified tuition and fees, IRA contributions, health insurance premiums for self-employed), with the one exception of 1/2 of any self-employment tax assessment.

* The tax liability will be calculated using the Standard Deduction.

It is not unusual to receive a bill from the IRS for assessed tax, penalties and interest on a reconstructed federal income tax return for $50,000 - $100,000!

Let us look at a real life example from my client files. FYI, in this case returns were file late due to medical reasons –

* The taxpayer’s 2002 Form 1040 was reconstructed by the IRS.

* Although the taxpayer had consistently filed his tax returns as Married Filing Joint in the past, his filing status for the reconstruction was Married Filing Separately.

* The calculation showed $260,610 in “total income reported by payers”.

* This included $205,000 in gross proceeds from the sale of investments reported on a Form 1099-B.

* There were no “adjustments to income” , the one personal exemption allowed was totally phased out due to the inflated AGI, and the Standard Deduction allowed for Married Filing Separately was claimed.

* The total tax assessment was $84,459, which after deducting withholding became $71,375 in net tax due. Adding interest of $4,823 and penalties for late filing, late payment and underpayment of estimated tax of $23,392 the total amount due came to $99,590!

The spouse only had W-2 income reported under her Social Security number. Her withholding was enough to cover the tax liability, even filing separately with no deductions, so she did not get a bill from the IRS. She also did not receive a refund for the overpayment on the reconstructed return.

Here are the facts from the 2002 Form 1040 that I eventually prepared –

* The joint total income was $128,751.

* After subtracting the cost basis of the investments sold there was a net capital loss, and the $3,000 maximum loss deduction was claimed.

* There were adjustments to income for the educator expenses and qualified tuition and fees.

* Schedule A was filed to report $40,961 in total itemized deductions.

* The couple had two dependent daughters and personal exemptions of $3000 each were claimed in full for 4 individuals.

* The final tax liability was $15,552, which was more than covered by withholding.
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While we eventually got everything straightened out with the IRS, as a result of the late filing the taxpayer became subject to “back-up withholding” and for several years had 28% in federal income tax withheld from his interest and dividend income, which reduced the potential accrued earnings on this money.

You should note that even if there is an overpayment on the properly constructed return the taxpayer will not receive a refund if that return is not received by the IRS within 3 years of the original due date for the return. While the three-year clock for audit purposes begins on the date the return is actually filed, the clock for refunds begins on the actual due date for the return.

In the case of a taxpayer who was convinced that he no longer had to file once he turned age 65, he became our client only after the IRS attempted to foreclose on his home to pay his reconstructed debt!

If you receive a reconstructed return, which is referred to by the IRS as a “Substitute For Return” (SFR), you should not file an amended Form 1040-X to report the correct information. While an SFR is considered to be a valid tax return it does not constitute an original return filed by the taxpayer. In the above case I filed an original 2002 Form 1040.

So if you want to avoid hassles with the IRS, possible excessive penalties and interest, and a potential lien on your personal residence you should always file your income tax returns on time, even if you do not have the money to actually pay the tax due. It is much “more better” to submit a balance due return with no payment than to submit nothing at all.

And if you have not filed your 1040 for the past year or two or three, get thee to a tax professional!

TTFN