Suppose you have unexpected medical expenses and you’ve exhausted your disposable funds. If there’s nowhere else to turn, consider an unconventional source.
Strategy: Tap into your 401(k) or IRA in a pinch. The distribution is taxable as ordinary income, but you may qualify for a special exception to the penalty for early withdrawals.
Normally, if you withdraw funds from a qualified plan like a 401(k) or an IRA prior to age 59½, you owe a 10% tax penalty on top of your regular income tax bill. But there are several key exceptions in the tax law.
One little-noticed exception applies to payments for medical expenses to the extent your unreimbursed expenses exceed the adjusted gross income (AGI) threshold for the medical deduction. Beginning in 2013, the AGI threshold for most taxpayers is 10% (up from 7.5% in 2012).
But this isn’t a slam-dunk by any means. If the IRS challenges your claim, you may have to prove that you qualify in court.
New case: A taxpayer who was under age 59½ received a retirement plan payout. He intended to roll over this amount directly into another plan. But he found out that his wife was pregnant and, based on prior history, anticipated she would have medical problems. So he never completed the rollover. Instead, the taxpayer used the money to pay medical bills and to get the baby’s room ready.
Although the taxpayer didn’t dispute that the distribution was taxable, he claimed the exception from the 10% tax penalty based on medical expenses. But the Tax Court disagreed. It said that he didn’t qualify for the exception due to the following reasons:
- He didn’t substantiate specific amounts used for medical expenses.
- He failed to show that the expenses were not reimbursed under his insurance policies.
- Even if he had provided proper documentation, his expenses didn’t exceed the 7.5%-of-AGI threshold.
As a result, the taxpayer was required to pay the 10% tax penalty. (McGraw, TC Memo 2013-152)
Tip: Use this technique only as a last resort. Withdrawals will reduce your nest egg intended for retirement.