Generally, distributions from a traditional IRA and qualified plans are taxed at ordinary income rates reaching up to 37%, plus a 10% penalty tax applies to withdrawals made prior to age 59½. Fortunately, the tax law provides numerous exceptions to the penalty tax. For example, no penalty is imposed on a series of substantially equal periodic payments (SEPPs).
As you might expect, another exception applies to distributions used to pay for medical expenses, such as physician and dental visits and hospital stays. But this exception includes a special limit. It only covers distributions to the extent that they exceed the prevailing medical deduction threshold.
Currently, the medical deduction is 7.5% of adjusted gross income (AGI). It was temporarily raised to 10% of AGI before Congress permanently returned the limit to the 7.5%-of-AGI mark. In any event, clearing this threshold can be daunting.
New case: A taxpayer was laid off from his job in 2013. To help with his financial situation during unemployment, he arranged to receive a distribution of more than $37,000 from his retirement account. He had not yet reached the age of 59½ at the time of the distribution. Accordingly, the IRS assessed the penalty tax on top of the regular income tax.
Although the taxpayer testified that he had consulted doctors during 2013 and paid medical insurance premiums after he lost his job, he didn’t submit documentary evidence of any kind to support that assertion.
Key point: The exception from the 10% penalty tax for early withdrawals from qualified plans and IRAs only applies to amounts that would have been deductible as medical expenses in excess of the annual threshold. For the tax year in question, the limit was 10% of AGI. Even if the taxpayer had properly substantiated his alleged medical expenses—which he did not—he didn’t exceed the 10%-of-AGI threshold.
As a result, the taxpayer is liable for the 10% penalty tax on the full amount of his retirement plan distribution. (Salter, TC Memo 2022-29, 4/5/22)
Tip: The exception for medical expenses can be claimed whether or not you itemize deductions on your tax return. But the limit based on 7.5% of your AGI applies in all cases.