The 10% penalty does not apply to distribution amounts that are less than or equal to an individual’s allowable medical expense deduction in excess of 7.5% of AGI (regardless of whether the individual actually itemizes deductions) if the distributions are used to pay for the medical care during the year (Sec. 72(t)(2)(B)). The penalty waiver only applies to that component of the distribution which is included in gross income. The income tax still applies to the taxable component of the distribution. The law does not require that individuals first deplete the 10% penalty exception for medical care by using the non-taxable component of a distribution, such as a non-taxable return of investment (Argyle v. Commissioner, T.C. Memo, 2009-218). A Form 5329 with an accompanying medical expense worksheet (or Schedule A for itemizers) must be attached to Form 1040, indicating Exception 5 on Line 2 of the Form
EXAMPLES:
- Without Itemizing Deductions and Claiming the Standard Deduction: Mr. and Dr. Nolan, both age 50, have an AGI of $40,000 for the year 2020, which includes an early retirement plan distribution. The Nolan family incurs and actually pays $9,500 in qualifying medical expenses during the year. The allowable medical deduction will be the amount of medical expenses that exceeds 7.5% of $40,000 or $3,000. Although the Nolans claim the standard deduction of $24,800 for 2020, their allowable medical expense deduction for 2020 would have been $6,500 ($9,500 in medical expenses less $3,000) had they itemized deductions on their Schedule A. In this example, a $5,000 taxable distribution from an IRA or retirement plan would not be subject to penalty. However, if the taxable distribution was $8,000, only $6,500 would escape the 10% penalty. The balance of the distribution, $1,500 will be subject to a 10% penalty of $150.
- When Itemizing Deductions: Dr. and Mrs. Kim, both age 40, have an AGI of $150,000 for the year 2020, which includes an early retirement plan distribution. The Smiths incur (and actually pay) $27,500 in qualifying medical expenses during the year. The allowable medical deduction will be the amount of medical expenses that exceeds 7.5% of $150,000 or $11,250. Their allowable deduction for 2020 is $16,250 ($27,500 in medical expenses less $11,250). In this example, a $15,000 taxable distribution from an IRA or retirement plan would not be subject to penalty. However, if the taxable distribution was $21,000, only $16,250 would escape the 10% penalty. The balance of the distribution, $4,750 will be subject to a 10% penalty of $475.
LIGHTENING THE LOAD: It is important to understand that substantial tax benefits are available to those caring for children with special needs.
Note: The key to this penalty exception in both examples – The taxpayers must have actually paid the medical costs during the year. However, there is a caveat: to the extent the distribution is included in gross income, AGI increases, reducing the medical expense deduction and increasing the distribution’s exposure to the penalty! It should also be noted that with regard to an IRA distribution, the law applies the medical expense exception before other exceptions; notably, the first-time homebuyer and education exceptions (Sec. 72(t)(2)(E) and (F)). As a result, families with significant unreimbursed medical expenses may wish to consider utilizing the medical expense exception first with regard to retirement plan distributions, availing themselves of the first-time homebuyer and educational exceptions under the IRA distribution rules (Blankenship, Vorris “Retirement Plans, IRAs, and Annuities: Avoiding the Early Distribution Penalty” The Tax Advisor, April 2011, p. 260)
CONCLUSION
This article provides a brief overview on the medical expense deduction and two common tax-savings opportunities in financing the medical expense deduction. As parents and advisers, it is important to understand that substantial tax benefits are available to those caring for children with special needs and the medical care financing options available that provide either a tax incentive or disincentive.•
(Reprinted in part with permission from MassMutual’s SpecialCare Spring 2020 Newsletter)
ABOUT THE AUTHOR:
Thomas M. Brinker, Jr., CPA/PFS, ChFC®, CGMA, CFE, AEP is Professor of Accounting at Arcadia University in Glenside, Pennsylvania. He is currently Executive Director for their MBA program and serves as Chair for the MassMutual Center for Special Needs Planning at the American College of Financial Services in King of Prussia, Pennsylvania. He graduated cum laude from Saint Joseph’s University in Accountancy, and holds master’s degrees in Taxation and Accounting from Widener University. In addition to earning his J.D., Professor Brinker earned an LL.M. in International Taxation from Regent University School of Law, where he received the distinction of “Outstanding Graduate” in his class. Mr. Brinker is also a member of the American and Pennsylvania Institutes of Certified Public Accountants, the International Bar Association, and the Caribbean Bar Association. In addition to presenting nationally and internationally on various tax topics, he has published dozens of articles in numerous journals, including The Journal of Accountancy, The Journal of International Taxation, The Tax Adviser, The CPA Journal, The Journal of Practical Estate Planning, and The Journal of Financial Services Professionals.