Distribution from 401(k) plan taxable to taxpayer with diabetes

A taxpayer who had diabetes but was able to control it with insulin and other medication could not exclude a distribution from a Sec. 401(k) plan from income and was subject to the Sec. 72(t) addition to tax for premature distributions on it.

Background

In 2017, Robert Lucas, a software developer, lost his job, causing him to experience financial difficulties. To make ends meet, he obtained a distribution of $19,365 during that year from a Sec. 401(k) plan account he owned that was administered by Matrix Trust Co. He had not reached age 59½ at the time, and Matrix accordingly reported this amount as an early distribution with no known exception on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

For 2017, Lucas reported the distribution on his federal income tax return but did not include it in his taxable income. Lucas had been diagnosed with diabetes in 2015, but he had been effectively treated with insulin shots and other medications. He did not include the 401(k) distribution on his return because he believed that the distribution did not constitute income due to his medical condition.

The IRS thought differently and issued Lucas a notice of deficiency for the 2017 tax year. The deficiency of $4,899 was based on the inclusion of the 401(k) distribution in his 2017 gross income and the 10% additional tax imposed by Sec. 72(t) for premature distributions from qualified retirement plans. Lucas challenged the IRS’s determination in the Tax Court.

The Tax Court’s decision

The Tax Court held that Lucas was required to include the distribution from his 401(k) in income in 2017 and was subject to the Sec. 72(t) addition to tax.

Income exclusion: As the Tax Court explained, gross income, under Sec. 61(a), includes all income from whatever source derived, except as otherwise provided. Under Secs. 61(b), 72(a)(1), 402(a), and 401(b)(2) and Tax Court precedent, this definition includes distributions from employees’ trusts. One type of employees’ trust is a 401(k) plan.

Although it was undisputed that Lucas received a distribution from his 401(k) plan in 2017, he asserted in Tax Court that this distribution should be excluded from his gross income because of his diabetes, relying on information from a website that (in his view) spoke to these matters.

The Tax Court first found that the website Lucas relied on addressed the applicability of the early-withdrawal penalty in cases of disability, which it noted is a distinct subject from whether the distribution counts as income for those experiencing a disability. More significantly, the court stated, the website does not constitute legal authority, and nothing in the Code, regulations, or the relevant case law supported Lucas’s interpretation. Therefore, the court concluded that the retirement distribution income must be included in his 2017 gross income.

Sec. 72(t) addition to tax: Under Secs. 72(t), 401(k), and 4974(c), distributions from a qualified retirement account (which, as noted above, includes a 401(k) account) to a taxpayer under 59½ years of age at the time of the distribution are subject to a 10% additional tax unless an exception applies. One of these exceptions, provided under Sec. 72(t)(2)(A)(iii), is for a distribution “attributable to the employee’s being disabled within the meaning of subsection (m)(7).” Under Sec. 72(m)(7) and Regs. Sec. 1.72-17A(f)(1), a taxpayer is considered disabled if, at the time of the disbursement, the taxpayer is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”

Although Regs. Sec. 1.72-17A(f)(2) identifies diabetes as an impairment that “would ordinarily be considered as preventing substantial gainful activity,” it clarifies that “[a]ny impairment, whether of lesser or greater severity, must be evaluated in terms of whether it does in fact prevent the individual from engaging in his customary or any comparable substantial gainful activity.” The Tax Court observed that Lucas was diagnosed with diabetes in 2015 but was able to work as a software engineer for two years after that diagnosis, including the year that he received the distribution from his 401(k) plan account, and that he was effectively treating his diabetes with a mix of insulin shots and other medications. Thus, the court found that the diabetes did not render him “unable to engage in any substantial gainful activity” within the meaning of Sec. 72(m)(7) and its accompanying regulations, and therefore Lucas was subject to the Sec. 72(t) addition to tax on the 401(k) plan distribution.

Reflections

As this case shows, having a specific ailment that could cause a qualifying disability for a Sec. 72(m)(7) exception to the Sec. 72(t) addition to tax is not enough; the ailment must have actually caused a disability that prevents “any substantial gainful activity.” If the taxpayer can control a condition and continue to work at the same job, the exception does not apply.

Although its provisions would not have helped Lucas, the SECURE 2.0 Act passed at the end of last year (as part of the Consolidated Appropriations Act, 2023, P.L. 117-328) expanded the exceptions to Sec. 72(t). Effective immediately, the act provided a new exception for distributions to terminally ill participants. Also, the exception for public safety officers is extended to those who have at least 25 years of service with the employer sponsoring the plan and is expanded to corrections officers who are employees of state and local governments. Starting in 2024, participants who self-certify that they experienced domestic abuse can withdraw the lesser of $10,000, indexed for inflation, or 50% of the participant’s account. And, finally, the act amended Sec. 72(t) to allow for penalty-free withdrawals of up to $22,000 for “qualified disaster recovery distributions.”

Lucas, T.C. Memo. 2023-9

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.