Medical Expense Exception
Rev. 04/28/05, E-mail Alert 2005-8

IRS Information Letter Addresses 10% Penalty Exception on Medical Hardship Distribution

The IRS has issued an information letter addressing distributions from qualified plans being exempt from the 10% penalty for early distribution if the distribution was for medical expenses. The exempt amount is calculated based on unreimbursed medical expenses during the year of distribution minus 7.5% of the “adjusted gross income” (AGI) -- the amount on Form 1040, line 35 or Form 1040A, line 22 -- for the year of distribution. To qualify, these medical expenses must be unreimbursed by insurance or other reimbursement programs and made during the year of distribution. They must also be deductible under Code Section 213. Click here for an FAQ on Code Section 213 medical expenses.

Although the information letter does not specify certain details, it appears clear that it refers to a 401(k) hardship distribution. Keep in mind that hardship distributions are usually subject to the 10% penalty for withdrawal from a retirement plan before age 59½. The 401(k) final regulations clarified that a hardship distribution for medical expenses is based on the entire unreimbursed amount and not on the amount above the 7.5% AGI threshold. Thus, all Section 213 medical expenses qualify for a hardship distribution. The distribution may also be grossed-up for anticipated taxes to be paid.

To reiterate, the 10% penalty that applies on the under age 59½ hardship distribution for medical expenses, does not apply to amounts distributed for medical expenses satisfying the deduction rules. Specifically, the 10% exception only applies to deductible medical expenses that exceed the taxpayer’s 7½% of AGI limit. An individual does not have to be itemizing his or her deductions to take advantage of this exception.

To view the letter, click here.