More On Tax Planningfrom The Advisor's Professional Library
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
An appeals court has decided in Kim v. Commissioner of the Internal Revenue Service that the Tax Court properly upheld the 10% early distribution penalty against a partner in a law firm who rolled over funds from his employer's retirement plan into an IRA after leaving his position in the firm at age 56, but then withdrew funds from the IRA to pay for his and his daughter's education and other expenses.
The exception for distributions from pension plans made to employees after separation from service for those 55 or older didn't apply, the Seventh Circuit Court of Appeals court ruled in May, because the taxpayer withdrew money from his IRA, not his firm's pension plan. The court further ruled that the taxpayer's argument that his account was a SEP IRA and not a traditional IRA wasn't dispositive, because the Internal Revenue Code (IRC) doesn’t distinguish between types of individual retirement plans.
Fifty-six year-old Young Kim was an attorney who left his position as a partner in a law firm and enrolled in the London School of Economics. Employees who depart employment at age fifty-five and older may withdraw money from their employer's retirement plan; they must pay income tax on the withdrawal, of course, but they do not owe the 10% additional tax that the IRC imposes on most withdrawals before age 59 1/2. Kim had moved the funds from the law firm's retirement plan to an individual retirement account, but a rollover is not a taxable event. Kim then withdrew about $240,000 from the IRA and paid the income tax but not the 10% additional tax. The IRS concluded that he owed the 10% tax.
Kim sought review by the Tax Court. The court held that Kim owed the 10% tax on the withdrawn money.
On appeal, Kim argued that the 10% additional tax did not apply to a distribution from a pension plan “made to an employee after separation from service after attainment of age fifty-five.” However, the court ruled that the distribution from the IRA was not “made to an employee,” i.e., he was not an employee of the IRA's custodian. He had been an employee of the law firm, and therefore could have taken a distribution from its pension plan, but that's not what happened.
Kim withdrew money from an IRA, which is an individual plan, not an employer plan. Kim characterized his account a as a “SEP IRA” (“simplified employee pension”) as opposed to a “traditional IRA,” but the IRC does not distinguish among flavors of individual retirement plans. Before reaching age 59 1/2, Kim withdrew money from an individual retirement plan, rather than from his former employer's plan, and therefore must pay the 10% additional tax.
The Taxpayer’s Argument
Kim insisted that this Tax Court ruling made no sense. He noted that he could have taken the money from the law firm's pension plan without the 10% additional tax; so why should it matter that the money went from the law firm's plan to an IRA before being withdrawn? The answer is that the IRC says that it matters, and Kim did not contend that the IRC violates the Constitution. The court noted that many parts of the tax code are compromises. Why can an employee withdraw money from an employer's plan without the 10% additional penalty at age fifty-five but not age fifty-four? Why does the 10% additional tax apply to withdrawals at age fifty-nine and 181 days, but not fifty-nine and 183 days?
These questions cannot be answered by logical analysis. The IRC’s lines are arbitrary. The law firm's pension plan gave Kim a choice between taking the money and moving part or all of it to an IRA. He chose to roll over the entire balance, because he did not want to pay any income tax immediately. The IRC allowed Kim to extend the tax deferral at the cost of the 10% additional tax if he later took some of the money before age 59 1/2.
The appeals court noted that money deposited in pension plans and many IRAs is not subject to income tax until the funds (including interest and capital appreciation) are withdrawn. Tax deferral is expensive to the Treasury, so the IRC makes a taxpayer’s tax-deferral opportunities costly. Hence someone who puts money in an IRA can't take it out freely before age 59 1/2; the prospect of the 10% additional tax on an early withdrawal makes IRAs less attractive (and the 10% tax also compensates the Treasury for some of the revenue foregone from deferred payment of the income tax on sheltered funds).
The IRC offers an opportunity to avoid the 10% tax on withdrawals between age fifty-five and 59 1/2, but that opportunity is limited by the “to an employee” language, lest it effectively reduce the age of free withdrawal from 59 1/2 to 55. The interaction of these provisions is bound to seem irrational to many affected persons, but Congress has concluded that some lines of this kind are appropriate. The judiciary is not authorized to redraw the boundaries.
Fidelity Investments, which administers Kim's IRA, sent him a statement informing him that he owed income tax and the 10% additional tax. But the accountant who prepared his tax return omitted the 10% additional tax, which, coupled with the fact that the deficiency exceeded $5,000, also led to a substantial-understatement penalty.
Kim argued that the court lacked any evidence from his accountant, but with the appeals court ruling, the shortfall is now Kim's responsibility.