Most retirement plan distributions are subject to income tax and may be subject to an additional penalty if you take an early withdrawal. What’s considered early? In general, it’s when participants take money out of a traditional IRA or other qualified retirement plan before age 59½. Such distributions are generally taxable and may be subject to a 10% penalty tax.

Note: The additional penalty tax is 25% if you take a distribution from a SIMPLE IRA in the first two years you participate in the SIMPLE IRA plan.

Fortunately, there are several ways that the penalty tax (but not the regular income tax) can be avoided. However, the rules are complex. As the taxpayer in one new court case found, if you don’t meet the requirements, you’ll be forced to pay the penalty.

Basic rules

Some exceptions to the 10% early withdrawal penalty tax are only available to taxpayers who take early distributions from traditional IRAs, while others can only be used with qualified retirement plans such as 401(k)s.

Some examples of exceptions include:

• Paying for medical costs that exceed 7.5% of your adjusted gross income,
• Taking annuity-like annual withdrawals under IRS guidelines,
• Withdrawing money from an IRA, SEP or SIMPLE plan up to the amount of qualified higher education expenses for you, your spouse, children or grandchildren, and
• Taking withdrawals of up to $10,000 from an IRA, SEP or SIMPLE plan for qualified first-time homebuyers.

Facts of the new case

Another exception is available for the total and permanent disability of the retirement plan participant or IRA owner. In one case, a taxpayer took a retirement plan distribution of $19,365 before he reached age 59½, after losing his job as a software developer. According to the U.S. Tax Court, he had been diagnosed with diabetes, which he treated with insulin shots and other medications.

The taxpayer filed a tax return for the year of the distribution but didn’t report it as income because of his medical condition. The retirement plan administrator reported the amount as an early distribution with no known exception on Form 1099-R, which was sent to the IRS and the taxpayer.

The court ruled that the taxpayer didn’t qualify for an exception due to disability. The court noted that an individual is considered disabled if, at the time of a withdrawal, he or she 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.”

In this case, the taxpayer was previously diagnosed with diabetes, but he had been able work up until the year at issue. Therefore, the federal income tax deficiency of $4,899 was upheld. (TC Memo 2023–9)

Lessons learned

As the taxpayer in this case discovered, taking early distributions is one area where guidance is important. We can help you determine if you’re eligible for any exception to the 10% early withdrawal penalty tax.

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The Employee Retention Credit (ERC) was a valuable tax credit that helped employers that kept workers on staff during the height of the COVID-19 pandemic. While the credit is no longer available, eligible employers that haven’t yet claimed it might still be able to do so by filing amended payroll returns for tax years 2020 and 2021.

However, the IRS is warning employers to beware of third parties that may be advising them to claim the ERC when they don’t qualify. Some third-party “ERC mills” are promising that they can get businesses a refund without knowing anything about the employers’ situations. They’re sending emails, letters and voice mails as well as advertising on television. When businesses respond, these ERC mills are claiming many improper write-offs related to taxpayer eligibility for — and computation of — the credit.

These third parties often charge large upfront fees or a fee that’s contingent on the amount of the refund. They may not inform taxpayers that wage deductions claimed on the companies’ federal income tax returns must be reduced by the amount of the credit.

According to the IRS, if a business filed an income tax return deducting qualified wages before it filed an employment tax return claiming the credit, the business should file an amended income tax return to correct any overstated wage deduction. Your tax advisor can assist with this.

Businesses are encouraged to be cautious of advertised schemes and direct solicitations promising tax savings that are too good to be true. Taxpayers are always responsible for the information reported on their tax returns. Improperly claiming the ERC could result in taxpayers being required to repay the credit along with penalties and interest.

ERC Basics

The ERC is a refundable tax credit designed for businesses that:

• Continued paying employees while they were shut down due to the COVID-19 pandemic, or
• Had significant declines in gross receipts from March 13, 2020, to September 30, 2021 (or December 31, 2021 for certain startup businesses).

Eligible taxpayers could have claimed the ERC on an original employment tax return or they can claim it on an amended retur

To be eligible for the ERC, employers must have:

• Sustained a full or partial suspension of operations due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings due to COVID-19 during 2020 or the first three quarters of 2021,
• Experienced a significant decline in gross receipts during 2020 or a decline in gross receipts during the first three quarters of 2021, or
• Qualified as a recovery startup business for the third or fourth quarters of 2021.

As a reminder, only recovery startup businesses are eligible for the ERC in the fourth quarter of 2021. Additionally, for any quarter, eligible employers cannot claim the ERC on wages that were reported as payroll costs in obtaining Paycheck Protection Program (PPP) loan forgiveness or that were used to claim certain other tax credits.

How to Proceed

If you didn’t claim the ERC, and believe you’re eligible, contact us. We can advise you on how to proceed.

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A new law was recently signed that will help Americans save more for retirement, although many of the provisions don’t kick in for a few years. The Setting Every Community Up for Retirement Enhancement 2.0 Act (SECURE 2.0) was signed into law on December 29, 2022.

SECURE 2.0 is meant to build on the original SECURE Act of 2019, which made major changes to the required minimum distribution (RMD) rules and other retirement provisions.

Here are some of the significant retirement plan changes and when they’ll become effective:

• The age for beginning RMDs is going up. Employer-sponsored qualified retirement plans, traditional IRAs and individual retirement annuities are subject to RMD rules. They require that benefits start being distributed by the required beginning date. Under the new law, the age distributions must begin increases from age 72 to age 73 starting on January 1, 2023. It will then increase to age 75 starting on January 1, 2033.
• There will be higher “catch-up” contributions for 401(k) participants ages 60 through 63. Currently, participants in certain retirement plans can make additional catch-up contributions if they’re age 50 or older. The limit on catch-up contributions to 401(k) plans is $7,500 for 2023. SECURE 2.0 will increase the 401(k) plan catch-up contribution limits for individuals ages 60 through 63 to the greater of $10,000 or 150% of the regular catch-up amount. The increased amounts will be indexed for inflation after 2025. This provision will take effect for taxable years beginning after December 31, 2024. (There will also be increased catch-up amounts for SIMPLE plans.)
• Tax-free rollovers will be allowed from 529 accounts to Roth IRAs. SECURE 2.0 will permit beneficiaries of 529 college savings accounts to make direct trustee-to-trustee rollovers from a 529 accounts in their names to their Roth IRAs without tax or penalty. Several rules apply. This provision is effective for distributions after December 31, 2023.
• “Matching” contributions will be permitted for employees with student loan debt. The new law will allow an employer to make matching contributions to 401(k) and certain other retirement plans with respect to “qualified student loan payments.” The result of this provision is that employees who can’t afford to save money for retirement because they’re repaying student loan debt can still receive matching contributions from their employers into retirement plans. This will take effect beginning after December 31, 2023.

Just the beginning

These are only some of the many provisions in SECURE 2.0. Contact us if you have any questions about your situation.

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Socking away money in a tax-advantaged retirement plan can help you reduce taxes and help secure a comfortable retirement. If your employer offers a 401(k) or Roth 401(k), contributing to the plan is a smart way to build a substantial nest egg.

If you’re not already contributing the maximum allowed, consider increasing your contribution. Because of tax-deferred compounding (tax-free in the case of Roth accounts), boosting contributions can have a major impact on the amount of money you’ll have in retirement.

With a 401(k), an employee makes an election to have a certain amount of pay deferred and contributed by an employer on his or her behalf to the plan. The amounts are indexed for inflation each year and not surprisingly, they’re going up quite a bit. The contribution limit in 2023 is $22,500 (up from $20,500 in 2022). Employees age 50 or older by year end are also permitted to make additional “catch-up” contributions of $7,500 in 2023 (up from $6,500 in 2022). This means those 50 and older can save a total of $30,000 in 2023 (up from $27,000 in 2022).

Contributing to a traditional 401(k)

A traditional 401(k) offers many benefits, including:

• Contributions are pretax, reducing your modified adjusted gross income (MAGI), which can also help you reduce or avoid exposure to the 3.8% net investment income tax.
• Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.
• Your employer may match some or all of your contributions pretax.

If you already have a 401(k) plan, take a look at your contributions. In 2023, you may want to try and increase your contribution rate to get as close to the $22,500 limit (with an extra $7,500 if you’re age 50 or older) as you can afford. Keep in mind that your paycheck will be reduced by the amount of the contribution only, because the contributions are pretax — so, income tax isn’t withheld.

Contributing to a Roth 401(k)

Employers may also include a Roth option in their 401(k) plans. If your employer offers this, you can designate some or all of your contributions as Roth contributions. While such amounts don’t reduce your current MAGI, qualified distributions will be tax-free.

Roth 401(k) contributions may be especially beneficial for higher-income earners, because they don’t have the option to contribute to a Roth IRA. That’s because your ability to make a Roth IRA contribution is reduced or eliminated if your adjusted gross income exceeds certain amounts.

Looking ahead

Contact us if you have questions about how much to contribute or the best mix between traditional and Roth 401(k) contributions. We can also discuss other tax and retirement-saving strategies in your situation.

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If you own a business, you may wonder if you’re eligible to take the qualified business income (QBI) deduction. Sometimes this is referred to as the pass-through deduction or the Section 199A deduction.

The QBI deduction is:

• Available to owners of sole proprietorships, single member limited liability companies (LLCs), partnerships, and S corporations, as well as trusts and estates.
• Intended to reduce the tax rate on QBI to a rate that’s closer to the corporate tax rate.
• Taken “below the line.” In other words, it reduces your taxable income but not your adjusted gross income.
• Available regardless of whether you itemize deductions or take the standard deduction.

Taxpayers other than corporations may be entitled to a deduction of up to 20% of their QBI. For 2022, if taxable income exceeds $170,050 for single taxpayers, or $340,100 for a married couple filing jointly, the QBI deduction may be limited based on different scenarios. For 2023, these amounts are $182,100 and $364,200, respectively.

The situations in which the QBI deduction may be limited include whether the taxpayer is engaged in a service-type of trade or business (such as law, accounting, health or consulting), the amount of W-2 wages paid by the trade or business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the trade or business. The limitations are phased in.

Year-end planning tip

Some taxpayers may be able to achieve significant savings with respect to this deduction (or be subject to a smaller phaseout of the deduction), by deferring income or accelerating deductions at year-end so that they come under the dollar thresholds for 2022. Depending on your business model, you also may be able to increase the deduction by increasing W-2 wages before year-end. The rules are quite complex, so contact us with questions and consult with us before taking the next steps.

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