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 Ghaly was required to pay income taxes on the amounts withdrawn (to the extent those distributions were taxable) and was assessed an additional 10% early withdrawal penalty.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!
If something of value changes hands, you can bet the IRS considers a way to tax it. Here are six taxable items that might surprise you:
Surprise #1: Hidden treasure. In 1964, a married couple discovered $4,467 in a used piano they purchased seven years prior for $15. After reporting this hidden treasure on their 1964 tax return, the couple filed an amended return that removed the $4,467 from their gross income and requested a refund. The couple filed a lawsuit against the IRS when the refund claim was denied. The Tax Court ruled that the hidden treasure should be reported as gross income on the couple’s 1964 tax return, the year when the hidden treasure was found.
Tip: The IRS considers many things like hidden treasure to be taxable, even though they are not explicitly identified in the tax code.
Surprise #2: Some scholarships and financial aid. Scholarships and financial aid are top priorities for parents of college-bound children, but be careful — if part of the award your child receives goes toward anything except tuition, it might be taxable. This could include room, board, books, or aid received in exchange for work (e.g., tutoring or research).
Tip: When receiving an award, review the details to determine if any part of it is taxable. Don’t forget to review state rules as well. While most scholarships and aid are tax-free, no one needs a tax surprise.
Surprise 3: Gambling winnings. Hooray! You hit the trifecta for the Kentucky Derby. But guess what? Technically, all gambling winnings are taxable, including casino games, lottery tickets and sports betting. Thankfully, the IRS allows you to deduct your gambling losses (to the extent of winnings) as an itemized deduction, so keep good records.
Tip: Know the winning threshold for when a casino or other payer must issue you a Form W-2G. But beware, the gambling facility and state requirements may lower the limit.
Surprise 4: Unemployment compensation. The IRS confused many by making this compensation tax-free during the COVID-19 pandemic. Unemployment compensation income has since gone back to being taxable.
Tip: If you are collecting unemployment, either have taxes withheld or make estimated payments to cover the tax liability.
Surprise 5: Crowdfunding. A popular method to raise money is crowdfunding through websites. Whether or not the funds are taxable depends on two things: your intent for the funds and what the giver receives in return. Generally, funds used for a business purpose are taxable and funds raised to cover a life event are a gift and not taxable to the recipient.
Tip: Prior to using these tools, review the terms and conditions and ask for a tax review of what you are doing.
Surprise 6: Cryptocurrency transactions. Cryptocurrencies like Bitcoin are considered property by the IRS. So if you use cryptocurrency, you must keep track of the original cost of the coin and its value when you use it. This information is needed so the tax on your gain or loss can be properly calculated.
Tip: Using cryptocurrency for everyday financial transactions is not for the faint of heart because of how much recordkeeping is involved.
When in doubt, it’s a good idea to keep accurate records so your tax liability can be correctly calculated and you don’t get stuck paying more than what’s required. Please call if you have any questions regarding your unique situation.
Summertime means the 2020 tax filing season is firmly in the rearview mirror for millions of Americans. But summertime is also the season when the IRS sends letters to unlucky taxpayers demanding more money!
If you receive a notice from the IRS, do not automatically assume it is correct and submit payment to make it go away. Because of all the recent tax law changes and so little time to implement the changes, the IRS can be wrong more often than you think. These IRS letters, called correspondent audits, need to be taken seriously, but not without undergoing a solid review. Here’s what you need to do if you receive one.
Stay calm. Don’t overreact to getting a letter from the IRS. This is easier said than done, but remember that the IRS sends out millions of these correspondence audits each year. The vast majority of them correct simple oversights or common filing errors.
Open the envelope! You would be surprised how often taxpayers are so stressed by receiving a letter from the IRS that they cannot bear to open the envelope. If you fall into this category, try to remember that the first step in making the problem go away is to open the correspondence.
Conduct a careful review. Review the letter. Understand exactly what the IRS is explaining that needs to be changed and determine whether or not you agree with their findings. The IRS rarely sends correspondence to correct an oversight in your favor, but sometimes it happens.
Respond timely. The IRS will tell you what it believes you should do and within what time frame. Ignore this information at your own risk. Delays in responses could generate penalties and additional interest payments.
Get help. You are not alone. Getting assistance from someone who deals with this all the time makes the process go much smoother. And remember, some of these letters could be scams from someone impersonating the IRS!
Correct the IRS error. Once you understand what the IRS is asking for, a clearly written response with copies of documentation will cure most IRS correspondence audits received in error. Often the error is due to the inability of the IRS computers to match documents it receives (for example 1099s or W-2s) to your tax return. Pointing out the information on your tax return might be all it takes to solve the problem.
Certified mail is your friend. Any responses to the IRS should be sent via certified mail or other means that clearly show you replied to their inquiry before the IRS’s deadline. This will provide proof of your timely correspondence. Lost mail can lead to delays, penalties, and additional interest tacked on to your tax bill.
Don’t assume it will go away. Until receiving definitive confirmation that the problem has been resolved, you need to assume the IRS still thinks you owe them money. If no correspondence confirming the correction is received, you should follow-up with another written confirmation request to the IRS.
No one likes surprises from the IRS, but they do occasionally happen. Here are some examples of unpleasant tax situations you could find yourself in and what to do about them.
An expected refund turns into a tax payment. Nothing may be more deflating than expecting to get a nice tax refund and instead being met with the reality that you actually owe the IRS more money.
What you can do: Run an estimated tax return and see if you may be in for a surprise. If so, adjust how much federal income tax is withheld from your paycheck for the balance of the year. Consult with your company’s human resources department to figure out how to make the necessary adjustments for the future. If you’re self-employed, examine if you need to increase your estimated tax payments due in January, April, June and September.
Getting a letter from the IRS. Official tax forms such as W-2s and 1099s are mailed to both you and the IRS. If the figures on your income tax return do not match those in the hands of the IRS, you will get a letter from the IRS saying that you’re being audited. These audits are now done by mail and are commonly known as correspondence audits. The IRS assumes their figures are correct and will demand payment for the taxes you owe on the amount of income you omitted on your tax return.
What you can do: Assuming you already know you received all your 1099s and W-2s and confirmed their accuracy, verify the information in the IRS letter with your records. Believe it or not, the IRS sometimes makes mistakes! It is always best to ask for help in how to correspond and make your payments in a timely fashion, if they are justified.
Getting a tax bill for an emergency retirement distribution. Due to the pandemic, you can withdraw money from retirement accounts in 2020 without getting a 10% early withdrawal penalty, but you’ll still have to pay income taxes on the amount withdrawn. If you don’t plan for this extra tax you will be surprised with an additional tax bill. And you may still get an underpayment penalty bill from the IRS because you did not withhold enough during the year. You may also still receive an early withdrawal penalty in error because the IRS is still scrambling to update their systems with all of this year’s tax relief changes.
What you can do: Set aside a percentage of your distribution for taxes. Your account administrator may withhold funds automatically for you when you request the withdrawal, so check your statements. Your review should be for both federal and any state tax obligations. If the withholding is not sufficient, consider sending in an estimated tax payment. And if you are charged a withdrawal penalty, ask for help to correspond with the IRS to get this charge reversed.
No one likes surprises when filing their taxes. With a little planning now, you can reduce the chance of having a surprise hit your tax return later.
Coronavirus uncertainty abounds. Thankfully, by monitoring tax changes on your behalf, we can work together to navigate the right path for you and your family. Here is a round-up of tax-related laws and information to help with tax planning for 2020.
Early distribution penalty waived The 10% early distribution penalty on up to $100,000 of retirement withdrawals for coronavirus-related reasons is waived during 2020. New tax rules allow tax liabilities on these distributions to be paid over a three-year period. So if you need the funds, you won’t see your tax bill skyrocket in one year. Even better, you can return these distributions back into your retirement account over a three-year period and not be subject to the annual contribution limits. Action: This could be a great way to handle emergency payments until you receive a stimulus check, unemployment payments, or a pending small business loan.
Required minimum distributions (RMDs) waived for 2020 Required minimum distributions (RMDs) in the year 2020 for various retirement plans is suspended. The corresponding 50% penalty associated with not taking an RMD is also suspended in 2020.Action: Taking out distributions when the market takes a tumble can hurt retirement income for many years. This change allows you to wait to let the value in your retirement account rebound before you withdraw funds.
IRS installment agreement suspension The IRS is suspending payments of all amounts due from April 1 through July 15, 2020. If you do not pay your IRS installment payment during this time your installment agreement will not be in default. Interest will continue to accrue on these installment agreements. Action: Being on the bad side of the IRS is never fun. If you currently have an IRS installment agreement, look to take advantage of this delay.
Offers-in-compromise The IRS will allow you until July 15, 2020 to provide additional requested information for any pending offers-in-compromise (OIC) and will not close out the OIC during this time without your consent. The IRS is also suspending any payments due under an OIC until July 15, 2020.
Enforcement activities suspended? Not so fast…The filing and enforcement of liens and levies will generally be suspended. However, IRS Revenue Officers will continue to pursue high income non-filers and initiate other actions when warranted.
No new audits The IRS will not initiate new audits during this time, but will act to protect the statute of limitations.
A letter in the mailbox with the IRS as the return address is sure to raise your blood pressure. Here are some tips for handling the situation if this happens to you:
Stay calm. Try not to overreact to the correspondence. They are often in error. This is easier said than done, but remember the IRS sends out millions of notices each year. The vast majority of them correct simple oversights or common filing errors.
Open the envelope. You would be surprised at how often people are so stressed by receiving a letter from the IRS that they cannot bear to open the envelope. If you fall into this category, try to remember that the first step in making the problem go away is to simply open the correspondence.
Carefully review the letter. Understand exactly what the IRS thinks needs to be changed and determine whether or not you agree with its findings. Unfortunately, the IRS rarely sends correspondence to correct an oversight in your favor, but its assessment of your situation is often wrong.
Respond timely. The correspondence should be very clear about what action the IRS believes you should take and within what timeframe. Delays in responses could generate penalties and additional interest payments.
Get help. You are not alone. Getting assistance from someone who deals with this all the time makes going through the process much smoother.
Correct the IRS error. Once the problem is understood, a clearly written response with copies of documentation will cure most of these IRS correspondence errors. Often the error is due to the inability of the IRS computers to conduct a simple reporting match. Pointing the information out on your tax return might be all it takes to solve the problem.
Use certified mail. Any responses to the IRS should be sent via certified mail. This will provide proof of your timely correspondence. Lost mail can lead to delays, penalties and additional interest on your tax bill.
Don’t assume it will go away. Until a definitive confirmation that the problem has been resolved is received, you need to assume the IRS still thinks you owe the money. If no correspondence confirming the correction is received, a written follow-up will be required.
