Kott v. Commissioner: Early Retirement Plan Withdrawals

Kott v. Commissioner: A Stark Reminder on Early Retirement Plan Withdrawals

Navigating the rules around early withdrawals from a retirement plan can be like walking through a legal labyrinth. A recent decision by Judge Lauber in the case of Preston L. Kott v. Commissioner of Internal Revenue illuminates the pitfalls and penalties you might encounter. Let’s break down the essentials that the tax court had to deliberate upon based on Mr. Kott’s situation.

The Case Snapshot

Date Filed: July 14, 2015

Court: United States Tax Court

Docket Number: 30012-13S

Outcome: Ruling in favor of the Commissioner

Key Issues at Stake

10% Additional Tax on Early Withdrawals

Accuracy-Related Penalty for Significant Understatement of Income Tax

The Heart of the Matter

Premature Withdrawals and the 10% Additional Tax

In 2011, Preston L. Kott withdrew $13,264 from his 401(k) retirement plan. He was in financial distress, behind on his mortgage, and facing foreclosure. However, since he was under 59½ years old, these withdrawals were deemed ‘premature’ under tax law.

Why the 10% Additional Tax?

When he made the withdrawal, it was subject to a 10 percent additional tax applicable to early distributions from a qualified retirement plan, as per 26 U.S.C.S. § 72(t)(2). Unfortunately, financial hardship is not among the exemptions for avoiding this tax. Thus, his need to prevent foreclosure did not qualify him for an exemption.

The Onus of Proof

To claim an exemption, the taxpayer bears the burden of proof. Mr. Kott failed to argue convincingly that any statutory exemptions applied to his case. Additionally, he did not present evidence to qualify for the ‘first-time-homebuyer’ exemption.

The Hardship Distribution Fallacy

Mr. Kott referenced 26 C.F.R. § 1.401(k)-1(d)(3)(iii)(B)(4), which allows a 401(k) plan to distribute funds to prevent eviction or foreclosure. However, this rule merely permits the distribution and does not exempt it from the 10 percent additional tax under 26 U.S.C.S. § 72(t).

Accuracy-Related Penalty

Mr. Kott was also penalized for significantly understating his income tax, violating 26 U.S.C.S. § 6662(a) and (b)(2). This penalty applies when the understatement exceeds either 10 percent of the tax required to be shown on the return or $5,000, whichever is greater, and the taxpayer lacks reasonable cause and good faith. The understatement in question was over $18,000, and Kott had failed to report the distributions as income. Despite being misled by a statement from someone associated with the plan, federal law did not consider his situation as reasonable cause or show good faith.

Takeaways

• Understand the Rules
• Tax Implications: Withdrawing funds from a retirement plan before age 59½ generally incurs a 10 percent additional tax unless an exemption is met.
• Financial Hardship Isn’t a Get-Out-of-Tax-Free Card: Needing the money doesn’t exempt you from the additional tax.
• Keep Comprehensive Records
• Burden of Proof: The taxpayer must prove any claimed exemptions. Maintain thorough records and documentation.
• Seek Professional Advice
• Consult a Tax Advisor: Before making any retirement plan withdrawals, consult a tax advisor to understand the potential tax consequences.
• Accuracy is Crucial
• Report All Income: Failure to report distributions and refunds can lead to penalties.
• Good Cause and Good Faith: Merely admitting an error isn’t enough. You must show proactive efforts to assess and report your tax liability accurately.

Conclusion

The case of Kott v. Commissioner serves as a stark reminder of the tax complications associated with early retirement plan withdrawals. Staying informed and consulting professionals early can help you avoid such pitfalls. When it comes to taxes, proactive measures can save you from future headaches.