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Even in Upheaval, Pay Attention When Tapping Retirement Accounts

July 16, 2020, 8:46 AM

As part of the CARES Act (Public Law 116-136), Congress made it easier for taxpayers experiencing financial hardship due to the Covid-19 pandemic to tap their 401(k) plans and individual retirement accounts (IRAs).

That sounds great on its face, but taxpayers need to be aware of the rules: a recent U.S. Tax Court case made clear that failure to do so can trigger tax consequences.

The taxpayer in the case, Tamecca Seril, also known as Tamecca Tillard, is a mother of two children. In 2016, her oldest son was headed to Morehouse College. That same year, the taxpayer and her family experienced personal and financial hardship.

Based on information that she received from Morehouse, Seril anticipated that the cost of her son’s education, including living expenses, would be $54,000 per year. To pay for it, she made two withdrawals totaling $54,500 from her IRA: $16,500 on Jan. 8, 2016, and $38,000 on July 25, 2016. The brokerage firm withheld federal income tax of $3,800 on the latter.

She also made withdrawals totaling $15,099 from her 529 College Savings Program Account. Two of those distributions were paid to her, while a third distribution was paid directly to Morehouse.

When the taxpayer filed her 2016 return, she reported $54,500 of IRA distributions, but declared that only $39,500 was taxable. She also reported $24,664 as subject to the 10% additional tax.

The Internal Revenue Service flagged the return because of a mismatch between the reported income and the amounts on her forms 1099-R, used following distributions from retirement plans. As a result, the IRS sent a Notice CP2000.

Seril didn’t file a timely response, and the IRS issued a notice of deficiency. She answered the notice, explaining that she had withdrawn the $54,500 to cover her son’s education expenses. She stated that she intended to redeposit $15,000 (the portion she hadn’t reported), and requested a waiver of the 60-day rollover period. She also argued that the $38,000 distribution she had received on July 25 was exempt from the additional tax because she had used that money to pay for her son’s educational expenses.

She then filed a timely petition, making the same arguments and additionally requesting a refund of the $3,800, which was withheld by the brokerage firm because she believed it was exempt from tax.

The matter went to trial. At the close of trial, the court instructed the parties to file seriatim briefs. Seriatim is a Latin phrase meaning “one after the other.” In Tax Court, under Rule 151, the first party (typically, the IRS) is charged with filing an opening brief within 75 days after the trial’s conclusion, and the answering brief is due within 45 days after that (a reply brief may also be filed).

In this case, the IRS filed the opening brief on March 27, 2020, and the taxpayer filed her answering brief on April 27, 2020, offering proof that she had deposited $15,000 into her IRA that day.

The rules for IRAs are found under tax code Section 408. The tax treatment of the accounts, including the exemptions, is generally located at Section 408(d).

Under the rules, for a distribution to qualify under the rollover exception, the funds must be deposited into an eligible retirement account no later than 60 days after receipt. That’s a hard and fast rule, but the Treasury Secretary may waive the 60-day requirement “where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.”

The IRS didn’t waive the rule here, and the court believed that to be the right result. The taxpayer didn’t suggest that her brokerage firm prevented a timely rollover, nor did she offer any other evidence for a delay. Instead, she simply contended that it was her intention to roll over the funds. That’s not enough to qualify for a waiver, and thus the entire amount is taxable.

When the taxpayer made the withdrawal, she wasn’t age 59-1/2 or older. Under Section 72(t), a 10% penalty (sometimes referred to as an additional tax) applies to early withdrawals unless an exception applies.

Seril argued that she was entitled to an exception under section 72(t)(2)(E) for “qualified higher education expenses.” To qualify, educational expenses must be incurred in the taxable year in which the distribution is received. The $54,000 was an estimate of the cost of attendance for full-year attendance, not a bill, and Seril couldn’t prove that she paid that amount in 2016.

She did prove that she paid educational expenses totaling $19,092 in 2016: $9,283 from her 529 account, and $9,809 documented by bank statements ($5,816 of which also came from the 529 account). Only $3,993 appeared to have been paid from the IRA. That means the remaining $50,507 didn’t qualify for an exception and was subject to the additional 10% penalty, the court said.

With that, the Tax Court looked at the final issue: a 20% underpayment penalty under Section 6662(a), (b)(2). Under Section 6664(c)(1), it’s clear that an accuracy-related penalty isn’t appropriate “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” But it’s the taxpayer’s burden to show reasonable cause and good faith.

In this case, the Tax Court noted that Seril prepared her 2016 return when her life was unsettled. She tried to do the right thing by reporting the full amount of the IRA distributions but excluding a portion as nontaxable because she intended to roll it over. And, she only reported a portion of the distribution subject to the 10% additional tax because she thought she was entitled to an exemption for education expenses.

But, she got some things wrong. Her rollover wasn’t timely, and she didn’t calculate the exemption amount correctly. Those mistakes resulted in additional tax, but her actions proved that she acted in good faith and shouldn’t be subject to a penalty.

As taxpayers, we often try to do the right thing, but the rules can be complicated. Throw in external factors—like personal and financial hardships—and even the best of intentions can result in mistakes. To avoid making a bad situation worse, pay attention to rules and deadlines, and always document your actions.

The case is Seril v. Comm’r, T.C., No. 4491-19, 7/8/20.

This is a weekly column from Kelly Phillips Erb, the TaxGirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.

To contact the reporter on this story: Kelly Phillips Erb at kelly.erb@taxgirl.com

To contact the editors responsible for this story: Rachael Daigle at rdaigle@bloombergindustry.com; Colleen Murphy at cmurphy@bloombergtax.com

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