10% Penalty on Distribution

[Guest ttuck]

Facts: Distribution to alternate payee ("AP") pursuant to a QDRO occurred in 2009. The distribution was a direct rollover to the AP's 401(k) plan but in a separate account from AP's own 401(k) funds. 1099-R was issued with Code G. AP subsequently cashed out the entire amount that was rolled into the separate account with her employer's 401(k) plan. Approx. one month passed from the date the rollover contribution came into the separate account and when the total distribution was taken.

Comments: I know there is an exception to the 10% early withdrawal penalty under IRC 72(t)(2)© for distributions from a qualified plan to an alternate payee pursuant to a QDRO. In substance, I think this situation qualifies for the exception to the 10% penalty for early withdrawals, but I have concerns about the form of the transactions. The fact that the distribution from the participant's plan was rolled into a separate account within AP's employer's 401(k) plan concerns me. In effect, the plan adminstrator that acted on the QDRO, i.e. participant's plan administrator, did not pay the distribution directly to AP, but rather to the adminstrator of AP's employer's 401(k) plan as part of the direct rollover. The ultimate distribution to AP came from the separate account within her employer's 401(k) plan.

Question: Does anyone know if the 10% early withdrawal penalty can be avoided in this set of circumstances? Thank you.

[Bird]

Question: Does anyone know if the 10% early withdrawal penalty can be avoided in this set of circumstances?

I don't think so. It sounds like two events - 1) a direct rollover to the AP's plan, and 2) a distribution from that plan. It is unfortunate, to understate the case, that it happened that way.

[BG5150]

If an account was established in the first plan for the AP, then it would be QDRO money. But in the second plan, it becomes merely rollover money, and thus subject to the withdrawal penalty.

[Guest Sieve]

Bird/BG --

Can't an AP move QDRO money directly from one investment vehicle into another (such as from a 401(k) account into an IRA) and simply continue to have it titled so that it is not yet taxable--much like, prior to the inherited rollover rules, a non-spouse beneficiary could move funds to another custodian (still, of course, subject to the original custodian's distribution rules) without it being included in income at the time of the transfer (if the account was labelled properly)? Or is that not possible with QDRO assets, thus forcing the AP to retain funds in the plan/IRA where originally held at the time of the QDRO?

[Bird]

Can't an AP move QDRO money directly from one investment vehicle into another (such as from a 401(k) account into an IRA) and simply continue to have it titled so that it is not yet taxable--much like, prior to the inherited rollover rules, a non-spouse beneficiary could move funds to another custodian (still, of course, subject to the original custodian's distribution rules) without it being included in income at the time of the transfer (if the account was labelled properly)? Or is that not possible with QDRO assets, thus forcing the AP to retain funds in the plan/IRA where originally held at the time of the QDRO?

Not to my knowledge. I can see the potential for doing it in an IRA, at least from the perspective of how an account could be titled (although I still don't think it is possible), but I'm pretty certain that it couldn't be done in a plan - as a TPA, I can't really imagine creating a new source called "QDRO rollover" that would retain the penalty-free nature for an early withdrawal. It's just a rollover.

[Guest ttuck]

Thank you. I appreciated the comments.

My conclusion is consistent with what Bird said regarding two separate transactions. However, I think it is worth the effort to file an initial tax return reflecting the 10% penalty and then file an amended return without the penalty shortly thereafter with full disclosure of the facts in an attachment. I believe this avoids the accuracy related return penalty that could be imposed if the 10% early withdrawal penalty is not reflected on the original return and still gives AP a chance at legitimately avoiding the penalty via the amended return, full disclosure, and possible discussions with the IRS.

Again, thanks very much for the comments.

[Guest Sieve]

The 10% penalty is not reported on the 1040. It's on the 5329, which is an excise tax return. How do you propose amending that return?

I'd be careful with your approach . . .

[masteff]

The 10% penalty is not reported on the 1040. It's on the 5329, which is an excise tax return. How do you propose amending that return?

I'd be careful with your approach . . .

A refresher on the 5329 might be in order...

1) If the 5329 is required, it generally is an attachment to the 1040. 5329 is ONLY filed by itself if the taxpayer is not otherwise required to file for the tax year in question. When it's an attachment, any amendment is made via the 1040-X.

2) 5329 can actually be omitted in certain cases and the 10% penalty reported directly on the 1040. However I would file the 5329 in the case above as the tax payer will be amending to claim an exception to the penalty.

[Guest Sieve]

masteff -- You're right about the 5329 being filed with the 1040. I should have looked it up instead of relying on my memory as to the differences between filing the 5329 & 5330.