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What’s the difference between a tax-advantaged retirement account and a regular savings account? About 10% if you take a withdrawal too early. But could that early withdrawal tax penalty be unconstitutional age or disability discrimination? The U.S. Tax Court says no.
When U.S. taxpayers find their money stretched thin, it can be tempting to dip into their tax-advantaged retirement accounts to make up the difference. There is nothing stopping them from doing that. However, the U.S. tax code says that when they do they must generally pay an additional 10% tax on the amount they received. This is informally called the “early withdrawal tax penalty.”
The early withdrawal tax penalty doesn’t apply to everyone, though. Taxpayers who are at least 59 ½ years old, or are disabled (meaning their mental or physical health permanently or indefinitely prevents them from doing any gainful work) are exempt. That means that if a 60 year old retiree or a 40 year old disabled adult withdraws their retirement savings, they will effectively receive 10% more money than their 50 year old, able-bodied counterpart. (Other exemptions apply as well, but they are beyond the scope of this post.)
Sandra Conrad felt that this different treatment was unfair. She received 9 distributions totalling $61,777 from her qualified retirement plan in 2008. When it came time to file her taxes, rather than sending in the $6,177 early withdrawal tax penalty, she sent a statement saying the tax was arbitrary and capricious, and demanding a refund of similar additional taxes paid in 2005 through 2007. The IRS disagreed with Conrad and promptly sent her a statutory notice of deficiency for the unpaid “10% tax on premature distributions from a qualified retirement plan.” Conrad then asked the U.S. Tax Court to review her claims that the early withdrawal tax penalty was unconstitutional age and disability discrimination under the Fifth Amendment.
In reviewing Ms. Conrad’s complaint, the U.S. Tax Court had to review whether a law is constitutional applying one of two standards. Strict scrutiny applies when the law invades a substantive constitutional right or freedom (like the freedom of speech), or when it treats people differently because of a “suspect class” like race. If neither of those two things apply, then the court applies the much lower “rational basis test.”
Ms. Conrad’s economic interests were not a substantive constitutional right, and neither age nor disability is a suspect class, so the lower “rational basis test” applied. Under the lower standard, a law will be upheld unless there is no rational reason the federal legislature could have passed it in the first place. Courts give the legislature especially broad latitude when it comes to creating tax classifications. So it was up to Conrad to show that treating age and disability differently was hostile or oppressive discrimination against a person or class of people.
When the legislature passed the Tax Reform Act of 1986 containing current version of the early withdrawal tax penalty, it explained what it was doing:
“The absence of withdrawal restrictions in the case of some tax-favored arrangements allows participants in those arrangements to treat them as general savings accounts with favorable tax features rather than as retirement savings arrangements.”
The court explained, to accomplish the legislative goal of encouraging retirement savings, the law needed to impose a penalty for early withdrawals to avoid those accounts being used for other purposes. The fact that elderly and disabled taxpayers don’t have to pay that penalty makes sense under this rational basis because they are in the situation the tax-favored retirement plans were intended to pay for.
There are many reasons why a U.S. taxpayer may need to dip into assets they meant to save for retirement. An unexpected lay-off or natural disaster may make income scarce while expenses continue to pile up. When that happens, taking disbursements from a retirement savings account may help the taxpayer avoid accumulating debt or even facing bankruptcy. However, when attorneys and financial planners advise clients of these options, they must be sure to account for the early withdrawal tax penalty. It may not seem fair, but it is not unconstitutional.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding IRS tax penalties or need to refer your real estate client’s tax collections case, contact Joe Viola to schedule a consultation.