Avoid a penalty and tax surprise when withdrawing from retirement accounts

Retirement Account WithdrawalRetirement accounts that provide tax breaks have very specific rules that you must adhere to if you want to enjoy the financial rewards of those tax breaks. One of these rules defines when you can make a withdrawal from your retirement account. If you pull money too soon, you risk an IRS penalty. There are several exceptions to this rule, such as paying for qualified higher education expenses or paying for expenses if you become permanently disabled. In general, though, if you withdraw retirement funds before you reach age 59½, you’ll get a 10% penalty in addition to regular income taxes. In the April 2023 court case Magdy A. Ghaly and Laila Ryad v. Commissioner, the taxpayers learned this rule the hard way.

The facts

In 2018, Ghaly took two distributions from his retirement account.

Distribution #1: Withdrawal

Ghaly was laid off from his job. In 2018, he withdrew money from his retirement account to provide for his family. He requested and received a withdrawal of $71,147 from his retirement account. The retirement company gave him a Form 1099-R indicating the withdrawal was taxable.

Distribution #2: Deemed Distribution

In 2015, Ghaly took a loan from his retirement account. Because the loan followed certain IRS-approved guidelines, it was not considered a taxable distribution from his account that year. However, when Ghaly failed to repay that loan when it came due in 2018, it became a taxable distribution. His retirement company gave him a 1099-R tax form for the deemed distribution.

Ghaly had not yet reached age 59½ before either amount was distributed.

The findings

Ghaly attempted to restore those distributions to his account to avoid the tax on the distributions and the early withdrawal penalty. So, he opened two retirement accounts in 2020 and made the maximum contributions allowed for each account. The Tax Court ruled against the taxpayers, stating that Ghaly’s contributions in 2020 were irrelevant when determining if his 2018 distributions were taxable. He had to pay income taxes on the withdrawals (to the extent those distributions were taxable) with an additional 10% early penalty.

Planning a retirement account withdrawal?

If you plan an early withdrawal from a retirement account, understand whether the 10% penalty applies to you before withdrawing. Ghaly could have explored the substantially equal periodic payment exception or withdrawn money penalty-free if used as a hardship to pay for his health insurance while unemployed. The lesson is: please contact our RRBB advisors if you have questions about an early withdrawal you may be planning before you make it!


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