HARDSHIP DISTRIBUTION FROM RETIREMENT PLAN DOES NOT AVOID 10% PENALTY

In today's economic hard times, many employees are seeking early distribution from their qualified retirement plans at work to help cover expenses. If the plan allows for it, a "hardship" distribution can be made if due to an immediate and heavy financial need of the employee and is in an amount necessary to meet the financial need.

Such distributions are not subject to the 20% withholding tax applicable to early plan distributions. They are still subject to income tax in the hands of the beneficiary.

A taxpayer who received a hardship distribution claimed that the distribution was not subject to the 10% penalty of Section 72(t)(1), which imposes a penalty on distributions from qualified retirement plans before age 59 1/2, due to the financial hardship involved. The Tax Court, noting that while some exceptions exist for imposing the 10% penalty tax, determined that there is no exception for mere financial hardship in the law.

There is an exception from the 10% penalty for "disability" distributions. However, the definition of "disability" is fairly strict. A taxpayer is considered disabled for this purpose only if he is unable to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued or indefinite duration. The Treasury Regulations provide that only medical conditions of a nature so severe as to prevent substantial gainful activity result in a taxpayer's being considered disabled for this purpose.

The taxpayer failed this definition of "disability" on numerous levels. His doctor indicated that he would fully recover from his mental illness (relating to post-traumatic stress disorder from his job). He also continued to work at the same job after his "disability" and also engaged in a business activity throughout the year that required him to travel a significant distance numerous times. Further, he later got another job full-time job with another employer.

Thus, avoiding the 10% penalty is not possible simply due to financial hardship. Taxpayers seeking to avoid the penalty based on "disability" will also have to overcome a high threshold to avoid the penalty.

Dollander, TC Memo 2009-187