Ask The EDD Lawyer – Is It Ok To Take An Early Distribution From Your 401(k) Because Of A Financial Hardship? This Can Cost You Extra Taxes And Penalties

By Robert S. Schriebman

July 30, 2015

Introduction

Is it OK to take an early distribution from your 401(k) because of a financial hardship? The answer is both “yes” and “no.” On July 14, 2015 the US Tax Court answered both ways in the matter involving Preston L. Kott v. Commissioner., T.C. Summary Opinion 2015-42.

Background

Preston Kott (Kott) needed money. His home was going into foreclosure. He withdrew $13,000 from his 401(k) retirement plan even though he was under the retirement age of 59 1/2. Kott did not report the $13,000 distribution on his 2011 federal income tax return. The IRS imposed a 10% additional tax on his early distribution as provided in Internal Revenue Code §72(t)(1). In addition the IRS imposed a 20% accuracy-related penalty. Mr. Kott strongly disagreed with the IRS and went to the US Tax Court.

Kott argued that 401(k) regulations permit retirement plans to make distributions to employees for payment necessary to prevent eviction from the employee’s principal residence or to avoid foreclosure. This is known as a “hardship distribution.”

What the Tax Court Held

US Tax Court Judge Pugh agreed and disagreed with Kott. Judge Pugh stated that Kott was right when he argued that 401(k) regulations allow a hardship distribution to avoid an eviction or foreclosure. Fortunately for Kott the regulation permitted his 401(k) retirement plan to make the hardship distribution to him before he reached the age of 59 1/2. Unfortunately for Kott, the regulation did not exempt Kott from the 10% additional tax under section 72(t) for an early distribution. Therefore, Kott owes the 10% tax on the $13,000 distribution.

Judge Pugh then had to decide whether Kott owed an additional 20% penalty on his income tax, pursuant to IRC §6662 for the accuracy-related penalty for the underpayment of tax attributable to a substantial understatement of Kott’s 2011 income tax. The penalty will not be imposed if Kott acted with reasonable cause and in good faith when he prepared his 2011 tax return. What did Kott tell the judge?

During his trial Kott testified that he did not rely upon a professional advisor nor did he include the $13,000 distribution on his 2011 tax return. He told the judge that this failure was an oversight. Judge Pugh held that while Kott might have been able to, but did not, establish reasonable cause for omitting the 10% additional tax, he admitted that he did not consider the tax at the time he filed his return. Judge Pugh admired Kott’s honesty but held that his actions did not establish reasonable cause to throw out the 20% additional penalty for negligence in the underpayment of his tax.

Lesson Learned

Kott’s case is interesting and important. IRS regulations have the same force of law as a section of the Internal Revenue Code; a statute. Regulations are not advisory; you cannot take them or leave them. The 401(k) regulations are especially tricky. Preston Kott found out the hard way.

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure”, both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure”, both published by Commerce Clearing House.

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