Early retirement plan distributions

Dear Tax Talk,
When my girlfriend filed her 2001 tax return, she used the one-time withdrawal of $10,000 from a qualified retirement plan to buy her first home. Now, the Internal Revenue Service has sent us a bill asking for taxes on this withdrawal as though it is ordinary income plus a 10-percent penalty.

We did everything by the book, including attaching a Form 5329 to the return and thoroughly researching the tax filer booklet. There was no consistency in any of the (2001) literature between qualified retirement plan, individual retirement account, 401(k), pension and annuity phrases, making it impossible to determine if there were differences in using this exemption based on what type of retirement plan the money was coming out of. Our CPA felt that we were filing correctly, but we filed on our own without a CPA signature.

We called the tax filer hotline and they agreed, as well. After receiving the letter that they want to recover taxes from an incorrect filing, we reviewed the current literature vs. the old literature. In the current literature, it states that you can only take the $10,000 exemption if it is withdrawn from an IRA but not any other type of retirement plan. In the old literature, it does not specify. Had the literature been specific in 2001, we would have rolled the $10,000 into an IRA first and then withdrawn it. How would you proceed forward in presenting this case to the IRS? We can't afford a $4,000 bill and it seems unfair that the IRS would request this money given the inconsistency in their own literature. -- Brett

Dear Brett,
The tax rules are complex and not always as clear as they should be.

Although an IRA and a 401(k) are both qualified retirement plans, rules apply differently to each. With respect to an IRA, you can withdraw up to $10,000 to be used as a down payment on your first-time home purchase. The withdrawal is not subject to the 10-percent penalty normally imposed for early withdrawals. However, the amount withdrawn is subject to income tax as ordinary income. Of all qualified retirement plans, this rule only applies to IRAs.

Whether your girlfriend could have withdrawn the money from her 401(k), rolled it over to an IRA and then made the qualifying withdrawal depends on a host of other equally complex rules. But since she didn't structure the withdrawal in that fashion, it's not going to help her get out of the tax and penalty on this matter.

Although you can say that you relied on the literature and it was not clear to you, a misinterpretation will not help either. The law in this area is very clear since the exception was carved out, and the current literature on this matter probably has not changed much since it was first written.

The IRS sometimes can waive penalties such as late filing based on reasonable cause. However, in the case of early withdrawals, there is no leeway for the IRS to mitigate the penalty. There is no reasonable cause exception to this penalty in this situation.

Based on the $4,000 assessment it sounds like she didn't pay the income tax due either. I suggest you work out a payment arrangement with the IRS or perhaps borrow against the home.

You should also review her state income taxes to see if additional income tax is due on the withdrawal.