Hardship and Retirement Distributions – No Free Pass

A very common mistake on the part of IRA owners and plan participants is thinking that distributions taken because of their financial difficulties are tax and penalty free.

Hardship Withdrawals

There is no hardship withdrawal from an IRA. You have access to your IRA funds at any time, for any reason.

There is a hardship exception for distributions from employer plans which is optional. A plan does not have to include a hardship exception. The exception gives the plan participant access to plan funds that ordinarily would not be available for distribution.

Tax-Free Distributions

The only time an individual can take a tax-free distribution from an IRA or employer plan is when the distribution contains after-tax contributions that were made to the IRA or plan.  As a general rule, all retirement plan distributions are taxed as ordinary income. They are included in your income for the year the distribution was made. A distribution of tax deferred funds in an IRA or employer plan due to hardship is taxable to the IRA owner or plan participant.

Penalty-Free Distributions

Any distribution of IRA funds prior to age 59 ½ is subject to the 10% early distribution penalty when no exception to the penalty applies. Hardship is not an exception to the penalty.

The rules for employer plans are slightly different as there are exceptions to the age 59 ½ rule. For plan participants who separate from service in the year they turn age 55 or later, there is no 10% penalty on distributions taken from the plan. For certain federal, state or local public safety employees, the age drops to 50. For all others under age 59 ½ taking a hardship distribution from an employer plan, the 10% penalty will apply unless the plan participant qualifies for an exception to the penalty. Hardship is not an exception to the penalty.

What Not to Do

The scenario we see all too often is that of an individual who truly has fallen on hard financial times. They turn to their retirement account to help them out and take a distribution. The retirement account issues a 1099-R to the individual. Some individuals do not put the 1099-R amount on their tax return at all. Some do include the 1099-R but do not calculate and pay the 10% early distribution penalty. IRS contacts them, argues with them, and ultimately determines the amount owed. The individual feels that they are in the right and takes IRS to Tax Court where they universally lose.

The Tax Code is clear that these distributions are subject to income tax and the 10% early distribution penalty. The court cannot overlook the clear language in the code. Many times in court cases we see sympathetic statements from the judges but the end result is the same. The individual owes the tax and the penalty. Don’t compound the first error by trying to beat IRS on this in Tax Court.