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Lessons from the Tax Court: Medical exception for IRAs

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in Small Business Tax

If you withdraw funds from an IRA before age 59½, you’re generally assessed a 10% penalty tax on the taxable portion of the early withdrawal, in addition to the regular income tax liability, unless a special exception applies. The list of exceptions in the tax code includes the following:

  1. Distributions made to a beneficiary or estate on account of the IRA owner’s death
  2. Distributions made due to disability
  3. Distributions made as part of a series of substantially equal periodic payments
  4. Distributions made due to an IRS levy against the account
  5. Distributions that are qualified reservist distributions
  6. Distributions for first-time homebuyer expenses (subject to a lifetime $10,000 limit)  
  7. Distributions for higher education expenses
  8. Distributions for medical expenses to the extent they exceed the AGI threshold for deductible medical expenses.

Currently, the threshold for deducting qualified medical expenses is 10% of adjusted gross income (AGI) or 7.5% of AGI if you’re age 65 or older. The IRS interprets these rules narrowly, and it often prevails in the courts.      

New case: A 47-year-old taxpayer, a resident of Maine, was employed at a hospital. In 2011, she earned $33,866 and took a distribution from her IRA of $5,294. Then she used the distribution to pay for her son’s medical expenses.

On her 2011 return, the taxpayer elected head-of-household filing status and claimed a personal exemption for herself and a dependency exemption deduction for her daughter, but not her son. She did not report the IRA distribution as income or pay the 10% penalty, allegedly based on the advice of her accountant.

There’s no reason why the taxpayer should not be taxed on the IRA distribution. As for the 10% penalty tax, the special tax-law exception applies only if the medical expenses are paid on behalf of the taxpayer, a spouse or a dependent. But the taxpayer’s son wasn’t her dependent. Accordingly, the taxpayer in this case had to pay the 10% penalty on top of the regular income tax. (Ireland, TC Summary Opinion 2015-60)    

Tip: It didn’t matter that the taxpayer may have relied on erroneous advice from a tax pro.

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