By Jeremy T. Rodriguez, JD
Generally, taking distributions from an IRA or qualified plan before retirement age should be a last resort. Of course, life has its unexpected pitfalls and at times, earlier access to these funds is necessary. One of the ways the Tax Code tries to help taxpayers in difficult financial situations is through exceptions to the 10% early distribution penalty.
One of those exceptions is for qualified medical expenses that exceed a 10% of adjusted gross income (this threshold was increased under the Tax Cuts and Jobs Act). The expenses can be for yourself, a spouse, or even your dependents. Besides the income threshold, there are two other important qualification rules. First, the medical expenses must be otherwise deductible under the Tax Code. The annual IRS guidance in Publication 502 helps tax payers determine whether an expense is deductible (See https://www.irs.gov/publications/p502 ), Keep in mind that in additional to traditional medical costs (e.g., office visit co-payments, prescription costs, and medical equipment rental costs), the definition also includes insurance premiums, transportation costs to receive medical care, and qualified long-term care services.
Secondly, the expenses must be paid in the same year as the IRA or qualified plan distribution. All too often, people mistakenly think that expenses must be incurred in the year of distribution. Thankfully, that isn’t the case, which means a distribution from an IRA or qualified plan can be used to pay for an older medical bill that could be heading to collections, and still qualify for the 10% early distribution exemption.
While this sounds simple, timing is crucial. We saw this second element come into play in the case of Evers, et. ux. v. Commissioner (T.C. Summ. Op. 20087-140). In that case, Mr. Evers and his wife took out a $15,000 loan in 2003 to pay for infertility treatments. The loan was from a credit union and the infertility treatments were performed during the 2003 and 2004 tax years. Sometime in 2004, Mr. Evers lost his job, rendering him eligible for a distribution from his company’s 401(k) plan. Faced with job uncertainty and reoccurring loan payments, Mr. Evers requested a distribution of $16,250 from the qualified plan. He used the bulk of this money to pay off the credit union loan. At the time of the distribution, he was under age 59 ½.
When it came time to pay taxes, the Evers properly included the 2004 401(k) distribution on their annual return. However, they did not apply the 10% early distribution tax. The Evers believed that since the 401(k) distribution was used to pay off a loan that was taken out to pay for medical expenses, the exception from the 10% early distribution penalty should apply. While the IRS agreed that infertility treatments counted as qualified medical expenses, it held that the 10% penalty still applied. The matter then wound up in Tax Court.
Unsurprisingly, the Tax Court agreed with the IRS and held that the exception only applied to expenses actually paid in the year of the distribution. That means only those expenses paid for in 2004 would count towards the exemption from the early distribution penalty. Unfortunately for Mr. and Mrs. Evers, the vast majority of medical expenses were paid in 2003. In fact, during the 2004 tax year they only paid $110 in medical expenses, well below the adjusted gross income threshold. In the end, on top of everything else they dealt with, the Evers were stuck with a $1,625 tax bill (plus court costs and interest). The lesson here is, while you can rarely plan for medical expenses, it is important to understand all the tax implications with different sources of money before acting.