401(k) Distribution for First Home Purchase Included in Income and Subject to Penalty

Eli Noff, Esq., Partner
Mary F. Lundstedt, Esq., Associate

On August 8, 2019, in Soltani-Amadi v. Commissioner,[1] the Tax Court determined that Taxpayer's early distribution from her Internal Revenue Code (IRC) §401(k) retirement plan (401(k)) used for the purchase of her first home was includible in income and subject to the 10% early distribution penalty. This decision emphasizes the need for careful planning in the context of retirement plan distributions.

Facts

In tax year 2015, Taxpayer was not yet 55 years of age. She worked for State and participated in its retirement plan-established for the exclusive benefit of State employees or their beneficiaries. The 401(k) was a qualified plan under IRC §401(a) and exempt from income tax per IRC §501(a).

During tax year 2015, Taxpayer received a distribution from her 401(k) account to help finance the down payment for the purchase of her first home. Thereafter, she and her husband filed a joint tax return for tax year 2015. On the return, they did not report the distribution as income. Similarly, they did not treat it as an early distribution subject to additional tax under IRC §72(t). They contended that they had received tax advice indicating that there would be little to no tax from the distribution.

The IRS examined the 2015 return and issued a notice of deficiency attributable to the distribution and a 10% additional tax per IRC §72(t). Taxpayer timely responded to the notice of deficiency.

Analysis

The court first considered the taxability of employees' trust distributions per IRC §402. The court noted that a distribution from an IRC §401(a) employees' trust, which is exempt from tax under IRC §501(a), is taxable under IRC §72.[2] The court emphasized that:

[a]s a general rule, a distribution from a section 401(k) retirement plan is fully taxable pursuant to section 72 because the participant's contributions to the plan are made with "pre-tax dollars".[3]

Next, the court addressed the issue as to whether a 10% additional tax on the distribution applied under IRC §72(t). The court noted that, per IRC §72(t), an early distribution from a "qualified retirement plan" is subject to a 10% additional tax, unless it is an excepted type of distribution under §72(t)(2). The court clarified that a plan described in IRC §401(a), such as a trust exempt from tax under IRC §501(a), is a "qualified retirement plan."

The court then reviewed types of distributions excepted from the 10% additional tax, including a distribution from individual retirement plans for the purchase of a first home.[4] The court explained that the 10% penalty was created in order to discourage early withdrawals; however, the Taxpayer Relief Act of 1997[5] provided for an exception if the distribution comes from "an individual retirement plan" and is used for the purchase of a first home.

Although the court acknowledged that the term "individual retirement plan" is not defined in IRC §72, it noted that IRC §7701(a)(37)'s definition is generally applicable. That section indicates that "individual retirement plan" means either an individual retirement account per IRC §408(a), or an individual retirement annuity described in IRC §408(b). The court reasoned that the definitions describing those IRC §408(a) and (b) accounts do not apply to 401(k) accounts.

Conclusion

Unfortunately for Taxpayer, the court ruled that the withdrawal from her 401(k), even though used for the purchase of her first home, was both includible in income and subject to the 10% early withdrawal penalty.

Significantly, under slightly different circumstances, Taxpayer could have avoided the 10% penalty. Consider that if you have an old 401k from a former employer, you can roll the amount of money you need over to an IRA-avoiding the penalty. Just remember that rollovers can take time-so don't wait to start the paperwork.

If you have questions or concerns about retirement plan distributions, call Frost & Associates, LLC today at 410-497-5947.


[1] T.C. Summ. Op. 2019-19 (Aug. 8, 2019).

[2] IRC §402(a).

[3] T.C. Summ. Op. 2019-19, at 7 (citing Weaver-Adams v. Commissioner, T.C. Memo. 2014-73, at 5).

[4] IRC §72(t)(2)(F).

[5] Pub. L. No. 105-34, 111 Stat. 788 (1997).