Monday, May 2, 2011


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.



Anthony said...

If you got permission from the couple to tell their story on your blog, you should mention this.

Or maybe you just want to start *really* cutting down your number of clients.

Robert D Flach said...


What is the problem? No names were mentioned. No one but me knows who my clients are.


Anthony said...

I didn't say there was a problem. So long as you got permission from the clients, there isn't one.

You disclosed quite a bit of identifying information (former tax preparer, approximate ages, husband's medical condition, wife's employment status), and IRS regulations prohibit disclosure of all tax return information (not just identifying tax return information) without written consent.

Surely there are better ways to cut down on your number of clients if you can't handle the volume.

Robert D Flach said...

Does anyone else thing I did anything wrong in using a real life example, without names, numbers, or any specific personal information, to explain a tax topic?

Geez. From now on I will present any "case study" as if I made up the situation.