Taxing Lessons Case Summaries

Case — Medical Expense Exception to Early Withdrawal Tax

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TL Case Summ

THE QUESTION

Do funds taken from a qualified retirement plan to repay a prior year medical loan qualify for an exception to the early withdrawal tax?

THE DISPUTE

Taxpayer Says: The 2004 early withdrawal was used to reduce a loan taken out in 2003 for medical expenses. The loan repayment should be considered a payment of medical expenses in 2004, and the additional tax should not be assessed.

Internal Revenue Service Says:  The medical exception applies only to medical expenses actually paid in 2004. Repayment of the loan does not qualify.

THE LAW

From Internal Revenue Code Section 72(t)(1): Imposes a 10-percent additional tax on early distributions from qualified retirement plans.

From Internal Revenue Code Section 72(t)(2)(B): Provides that the imposition of the additional tax under section 72(t)(1) shall not apply to: Distributions made to the employee * * * to the extent such distributions do not exceed the amount allowable as a deduction under section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).

From Internal Revenue Code Section 213: Provides a deduction for expenses paid during the taxable year, not compensated by insurance or otherwise, for medical care of the taxpayer, his spouse or a dependent, to the extent that such expenses exceed 7.5 percent of the taxpayer’s adjusted gross income.

From Federal Tax Regulation 1.213-1(a)(1): The medical expense deduction under section 213 is allowable only with respect to medical expenses actually paid during the taxable year,  regardless of when the incident or event which occasioned the expenses occurred and regardless of the method of accounting employed by the taxpayer in making his income tax return.

THE CAUSE OF THE DISPUTE

If you’re under age 59-1/2, money you take from your retirement plans is generally subject to a 10% early withdrawal tax. The law provides exceptions to this additional tax, one of which involves payment of medical expenses. Though you don’t have to itemize to use the exception, it applies to medical expenses you pay for yourself, your spouse, or your dependents that would be deductible if you did itemize (which means expenses that are greater than 7.5% of your adjusted gross income).

In this case, the taxpayer took out a loan to pay medical expenses in 2003. In 2004, the taxpayer made a withdrawal from a retirement plan and used the withdrawal to pay down the loan. The taxpayer believes the 10% additional tax does not apply because the retirement plan distribution was used for medical expenses.

The IRS says the loan proceeds were used to pay the expenses in 2003, so the retirement plan withdrawal in 2004 does not qualify for the exception.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 12KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The clear language of section 72(t)(2)(B) limits the scope of the exception to the amount of deductible medical expenses paid during the taxable year of the distribution. The exception does not apply to the medical expenses taxpayers paid in 2003 because the taxable year of the early distribution was 2004.
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