Retirement account distributions typically trigger sizable tax liabilities. These liabilities often go unpaid, which results in unpaid tax debts and IRS collection enforcement actions. With careful planning, sometimes these taxes can be avoided.
Tax on Retirement Account Distributions
Most distributions from retirement accounts trigger income taxes. This includes distributions from IRAs and 401(k)s.
The idea is that the funds were contributed to the retirement account before tax, so no income tax has been imposed on the account assets before the distribution. Since there were no taxes on the account previously, there needs to be income tax on the distribution.
This happens when contributions are made to the retirement account by having an employer make the contributions by deducting the contributions from the employees pay. It can also happen when the taxpayer puts after-tax money into the account, but is then entitled to a tax deduction for the contribution.
Tax Free Retirement Account Distributions
Roth accounts are one of the exception to these rules. Roth accounts, be it an IRA or 401(k), are made on an after-tax basis. The taxpayer pays income tax on the amount prior to making contributions. Thus, it is not appropriate to tax the same money when it is distributed from the retirement account.
There are also a number of rules that allow retirement account distributions to escape income tax. One is for loans taken out from the retirement account. Some retirement accounts, such as 401(k)s, allow the account holders to take loans from the plan. These loans are not taxable income to the account holder if they are repaid timely, etc.
Rollovers from one account to another are also not taxable. But one has to actually deposit the distribution into another retirement account. One cannot merely report the distribution as a rollover. The court addressed this fact pattern in McCree v. Commissioner, T.C. Memo. 2019-67. The court upheld accuracy related penalties for the failure to report the retirement account distribution in this circumstance.
Additional Tax on Early Distributions
If the retirement account holder is under 59 1/2 years old at the time of the distribution, the law also imposes a 10 percent addition to tax on the distribution. This addition to tax is not imposed in some cases, such as when:
- The account owner is disabled, which means he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration
- The distribution is taken by way of an IRS levy on the retirement account
- The distribution is taken by an unemployed person and the funds are used for heath insurance
- The distribution is used for higher education expenses for education furnished to the taxpayer, the taxpayer’s spouse, or any child of the taxpayer or the taxpayer’s spouse, at an eligible educational institution
- The distribution is used by a first time homebuyer to purchase a home
Importantly, most of these exceptions only apply to IRAs. They do not apply to 401(k)s. The courts have confirmed that 401(k)s do not qualify. See, e.g., Soltani-Amadi v. Commissioner, T.C. Summary Opinion 2019-19.
On occasion, Congress has also provided exceptions for presidential declared disaster areas. For example, with Hurricane Harvey, Congress waived the penalty for those who were impacted by the storms.
Unpaid Tax Debts from Retirement Distributions
Taken together, the income tax on distributions and the early distribution tax can result in significant unpaid tax debts.
Taxpayers who find themselves with this type of unpaid tax debt will usually qualify for one or more of the collection alternatives for unpaid tax debts. This includes the IRS’s offer in compromise or various installment payment agreements.