10% Early Withdrawal Penalty Disability Exception

[geekgirldany]

I would appreciate any input from the forum about this topic.

I am helping a relative prepare their tax return.
She had to get out her retirement early and is subject to the 10% early withdrawal penalty.
I feel that she may be able to get the disability exception to the penalty but from my reading the IRS is not exactly interested in how bad the disability is but how long it will last... will it be indefinite.
The client has major depression for atleast 10 years. She sees a psychiatrist regularly and has applied for Social Security Disability but is having to go to a hearing. The last few years things got very bad for her. I really don't want to go into details but it was bad. Of course the family hopes she will get better but I don't know how much better.

I've read various tax court cases in regards to depression being a disability. Most cases were ruled in favor of the IRS but it appears these people tried to or continued to generate income in some fashion. My relative is not nor can I see ever being able to work again.

My question:
Would the best route be to file the return paying the penalty and then amending to include the disability exception?

The reason I am thinking this way is because the amount taken out of retirement is very large and so the penalty is pretty large. I would like to avoid letters from the IRS adding the penalty back to the return and including interest. Plus my relative really would not be able to deal with such a situation. So I thought filing the return and then amending would allow my relative to provide the documents from the doctor in regards to the disability and most importantly not be hounded by the IRS to pay the penalty. She would be given a chance to prove her disability.

Thank you all for any comments on this situation.

[Twin Turbo Z]

Did the defendants in the court cases have a Dr. backing them ?

[geekgirldany]

Two court cases did not or could not provide doctors statement as to their disability. One case letters from a doctor were provided as part of the evidence and the taxpayer won. Although it appears the doctor's letters did not determine the outcome. Coleman-Stephens case. I know court cases can not be used as precedent.

[taxea]

You don't have to wait for SS disability if you get her doctor to sign a disability form and provide medical documents proving the disability.

[kathyc2]

Just because the penalty is large it doesn't mean that the return will be pulled for examination if you claim the exemption.

For a person already struggling with depression, I agree an IRS notice would be traumatic. If a relative has POA I would consider using their address on the return so that if there is an inquiry they would be the one receiving any notice.

[New York Enrolled Agent]

The client has major depression for atleast 10 years. She sees a psychiatrist regularly and has applied for Social Security Disability but is having to go to a hearing.

Why not put her on extension and see if you get the SSD approved?

There is a high bar to establish disability under §72(m)(7). A mere doctor's letter is not sufficient.

You said you read some Tax Court cases. Make sure you read Dwyer 106 TC 337(1996). It sets the high bar. The taxpayer suffered (as your client) from depression. A snip follows but read the full case.

S. Rept. 93-383, supra at 134, 1974-3 C.B. (Supp.) at 213 states that "Generally it is intended that the proof [of disability] be the same as where the individual applies for disability payments under social security."

The regulations, promulgated pursuant to the statutory authorization contained in section 72(m)(7), provide that an individual will be considered to be disabled if he or she is unable to engage in any "substantial gainful activity" by reason of any medically determinable physical or mental impairment that can be expected to result in death or to be of long-continued and indefinite duration. .... Significantly, the regulations also provide that an impairment which is remediable does not constitute a disability.

Notwithstanding the apparent severity of petitioner's illness in 1989, which, according to Dr. Gardner, persisted into the spring of 1992, the illness did not fall within the definition of "disabled" as contemplated by sections 72(t)(1) and (2) and 72(m)(7), and the regulations thereunder. Petitioner continued to function as an active stock trader in the face of his clinical depression, and in fact withdrew his IRA funds to further that activity. Thus, his condition fails to meet the regulatory requirement that the individual be so impaired as to be unable to engage in any substantial gainful activity. Sec. 1.72-17A(f)(4), Income Tax Regs.

[geekgirldany]

Thank you all for responding.

NYEA, we really do not know when the hearing will be. This Summer according to the lawyer but many of my clients are still waiting for a hearing after two years. The case you cited is the one I was talking about where the taxpayer was able to generate income in another way. This one was a day trader and I believe another was a doctor. My relative is unable to work at all. I believe there is a good case.

Kathy... I guess what I am worried about on the 10% penalty being large ($17,000) is that if the IRS does not accept the disability exception there would be interest (can not think of a penalty that would apply) which depending on how long it is dragged out could be a fair amount. This is the only money she has to live on.

Just trying to figure out the best way to file the return while minimizing my relatives anxiety of receiving letters from the IRS demanding payment of the 10%.

I thought filing the return with her paying the penalty. Then a little later file amended return with the doctor's letter. Atleast the IRS has their money and if the attempt to prove disability fails there would be no additional interest to pay.

Just want it to be as easy on her as possible.

[New York Enrolled Agent]

I'll give you an OPINION- it will be hard to get the $17K back on amended return with simply a letter from a doctor.

If you truly believe he will qualify under section 72(m)(7) then file the return using Form 5329 requesting the waiver. I would also file a disclosure Form 8275 with the return detailing the SS hearing, etc. The disclosure will protect both taxpayer and preparer from possible penalties under sections 6662 and 6694. Ignore anyone who tells you the 8275 is an audit flag. It's Urban Legend.

[geekgirldany]

Thank you NYEA.

Never thought of using Form 8275....excellent thought. By filing it the penalties would be avoided and there would be a explanation in regards to the disability.
Yes, I know it will take more than a letter from the doctor. Probably medical records and/or letters from the SSA. I know there will more than likely be a lot of going back and forth with the IRS on it.

I really appreciate your opinion on it.

[DonB]

I would appreciate any input from the forum about this topic.

I am helping a relative prepare their tax return.
She had to get out her retirement early and is subject to the 10% early withdrawal penalty.
I feel that she may be able to get the disability exception to the penalty but from my reading the IRS is not exactly interested in how bad the disability is but how long it will last... will it be indefinite.
The client has major depression for atleast 10 years. She sees a psychiatrist regularly and has applied for Social Security Disability but is having to go to a hearing. The last few years things got very bad for her. I really don't want to go into details but it was bad. Of course the family hopes she will get better but I don't know how much better.

I've read various tax court cases in regards to depression being a disability. Most cases were ruled in favor of the IRS but it appears these people tried to or continued to generate income in some fashion. My relative is not nor can I see ever being able to work again.

My question:
Would the best route be to file the return paying the penalty and then amending to include the disability exception?

The reason I am thinking this way is because the amount taken out of retirement is very large and so the penalty is pretty large. I would like to avoid letters from the IRS adding the penalty back to the return and including interest. Plus my relative really would not be able to deal with such a situation. So I thought filing the return and then amending would allow my relative to provide the documents from the doctor in regards to the disability and most importantly not be hounded by the IRS to pay the penalty. She would be given a chance to prove her disability.

Thank you all for any comments on this situation.

Another approach would be to make an extension payment to cover the tax plus the additional 10% tax plus a little cushion in case there is an underpayment penalty. Then do not file the return until you have a determination from SSA. This could be a late filed return but with no penalties because there would be no balance due, just a refund. I have a client who always files two years late ???? with no problems because he always has excess withholding which he credits to the next year.

[spanel]

Another approach would be to make an extension payment to cover the tax plus the additional 10% tax plus a little cushion in case there is an underpayment penalty. Then do not file the return until you have a determination from SSA. This could be a late filed return but with no penalties because there would be no balance due, just a refund. I have a client who always files two years late ???? with no problems because he always has excess withholding which he credits to the next year.

Why on earth did she pull out $170,000?

Chris

[geekgirldany]

Thanks Don that is another good idea.

Spanel... it is the only money she has left. I won't go into details but this was a last resort. I looked into taking the 72(t) Distribution to avoid the penalty and taking out a specific amount over time paying the penalty. The last thing she needs to worry about is having enough money to live.
Like I said this person has been through so much and I tried/trying to make it the easiest I can for her.

I greatly appreciate everyone's input. It means a lot to me and my relative the time you all took to respond.

[Burke]

It's a shame she could not have spread the withdrawal over a few years. If it was a 401(k) and that was not possible, rolling over to an IRA would have given her more control.

[geekgirldany]

Hi Burke. Could you explain a little more about rolling it over into a IRA? From my understanding there would still be a 10% penalty on amounts withdrawn from a IRA.

[kathyc2]

Hi Burke. Could you explain a little more about rolling it over into a IRA? From my understanding there would still be a 10% penalty on amounts withdrawn from a IRA.

I believe what Burke meant is some 401K plans will not allow a partial distribution and if you want to take any distribution you need to take it all. The entire 170K could have been rolled to a IRA penalty free. Then each year only taking from the IRA what is needed each year. The penalty would only apply to the amount withdrawn each year and most likely would have been at lower marginal rates if spread over a few years.