Avoid a Penalty and Tax Surprise when Withdrawing from Retirement Accounts

Retirement accounts that provide tax breaks have very specific rules that must be followed if you want to enjoy the financial rewards of those tax breaks.

One of these rules defines WHEN you're allowed to pull money from your retirement accounts. If you pull money too soon, you're at risk of being levied with a penalty by the IRS. There are several exceptions to this rule, such as paying for qualified higher education expenses or paying for expenses if you become permanently disabled. In general, though, if you withdraw retirement funds before you reach age 59½, you'll be hit with a 10% penalty in addition to regular income taxes. In the April 2023 court case Magdy A. Ghaly and Laila Ryad v. Commissioner, the taxpayers learned this rule the hard way.

The Facts

In 2018, Mr. Ghaly took two distributions from his retirement account.

Distribution #1: Withdrawal

Mr. Ghaly was laid off from his job, and in 2018, he withdrew money from his retirement account to provide for his family. He requested and received a withdrawal of $71,147 from his retirement account. His retirement company provided him with a Form 1099-R indicating the withdrawal was taxable.

Distribution #2: Deemed Distribution

In 2015, Mr. Ghaly took a loan from his retirement account. Because the loan followed certain IRS-approved guidelines, it was not considered a taxable distribution from his account that year. However, when Mr. Ghaly failed to repay that loan when it came due in 2018, it became a taxable distribution. His retirement company provided him with a 1099-R tax form for the deemed distribution.

Mr. Ghaly had not yet reached age 59½ before either amount was distributed.

The Findings

In an attempt to restore those distributions to his account to avoid both the tax on the distributions and the early withdrawal penalty, he opened two retirement accounts in 2020 and made the maximum contributions allowed for each account.

The Tax Court ruled against the taxpayers, stating that the contributions Mr. Ghaly made in 2020 were irrelevant when determining if his 2018 distributions were taxable. Mr. Ghaly was required to pay income taxes on the amounts withdrawn (to the extent those distributions were taxable) and was assessed an additional 10% early withdrawal penalty.

The Lesson

If you are planning an early withdrawal from a retirement account, understand before making the withdrawal whether the 10% penalty applies to you. In Mr. Ghaly's case, he could have explored the substantially equal periodic payment exception or withdrawn money penalty free if used as hardship to pay for his health insurance while unemployed. The lesson: please call if you have questions about an early withdrawal you may be planning before you make it!