Catania v. Comm’r, T.C. Memo. 2021-33 (2021)
Available at https://dawson.ustaxcourt.gov/case-detail/13332-19
The Tax Court has affirmed the IRS’s determination that a former 401(k) plan participant who took a distribution from his rollover IRA before reaching age 59-1/2 was liable for the 10% additional tax on early distributions. The participant had retired at age 55 and transferred the balance of his 401(k) account into a traditional rollover IRA. Two years later, the participant took a distribution from the IRA and reported the distribution as income, but did not pay the 10% additional tax on early distributions under Code § 72(t)(1). The IRS issued a notice of deficiency for the additional tax, and the participant petitioned the Tax Court for relief, claiming that the distribution should not be subject to the 10% additional tax because the distribution occurred after his separation from service after attaining age 55.
The Tax Court sustained the IRS’s determination, explaining that the exception to the 10% additional tax for post-separation distributions after attaining age 55 applies to other qualified retirement plans but not to distributions from an IRA. Although the funds initially came from a 401(k) plan, the distribution two years later from a traditional IRA was subject to the 10% additional tax. The court expressed sympathy for the participant’s situation, but noted that it lacked the authority to craft an equitable or hardship exception to the tax.
EBIA Comment: This case highlights a trap for the unwary. Participants who take post-separation distributions from their employer’s plan after attaining age 55 (and before age 59-1/2) might assume that the post-separation exception to the 10% additional tax also applies to subsequent distributions of those funds from their rollover IRAs, but it doesn’t. The IRS’s model rollover notice warns about this difference (see our Checkpoint article). The warning is the first item in a list of tax differences for payments from an IRA, but it is easy to see how that warning could be missed. Participants who see the exception for post-separation distributions might not read on to find the part of the notice explaining how the exception doesn’t apply to distributions from a rollover IRA. With the example of this case in mind, sponsors might consider modifying their notices to supplement the first mention of the post-separation exception with a warning to keep reading because the rules for IRAs are different. And advisors will want to be sure that clients who are under age 59-1/2 understand this tax difference when they consider whether to roll a distribution into an IRA. For more information, see EBIA’s 401(k) Plans manual at Section XIV.K (“10% Additional Tax on Early Distributions”).
Contributing Editors: EBIA Staff.