Posted by In mathematics, the order in which operations is performed is critical to obtaining the correct outcome. There is an ordering convention which is prescribed – Parentheses (do the operation within the parentheses first), Exponents, Multiplication, Division, Addition, Subtraction. For example, 5 x 3 – 2 = 13, but 5 x (3 – 2) = 5. Generally, we perform these subconsciously either because we had a good teacher who explained the logic or good materials which showed the logic or because of drill and kill which made defying the logic painful.
Taxation is somewhat like mathematics. The order in which operations are performed is often critical. A prime breeding ground for anomalies is in distributions from retirement accounts – either 401(k) plans or IRS’s. If you wish to take distributions from an IRA to pay “qualified higher education expenses” without incurring the 10 percent early withdrawal penalty, you can do that because there is an exception in Code Section 72(t)(E). You still pay income tax on the withdrawal, but not the 10 percent penalty.
There is no such exception for withdrawals from a 401(k). Whether there should be is a matter to argue before Congress, not with your return preparer.
Now suppose you have an opportunity to roll over the funds from your 401(k) to an IRA. Can you do that tax-free and without the penalty? Sure. Could you then withdraw the funds from the IRA and avoid the penalty? Sure. Then why can’t you withdraw the funds from the 401(k) and roll over the rest to an IRA. Answer – because that is not how the statue is written.
Suppose taxpayer Siegfried turns 59 on January 1. He will be 59 ½ during that year. Can he take out the funds on March 15 and avoid the penalty. No. He turns 59 ½ on July 1 and, to be safe, will wait until July 2 to withdraw any funds.
Suppose taxpayer Sieglinde is retired and turns seventy on January 1, 2020 and wishes to use some of her retirement money for charitable purposes. She is still under the “old” rules – she turns 70 ½ during 2020 and so must take out approximately 3.6 percent of her retirement funds as a required minimum distribution during the year or by April of the following year. If the fund is an IRA, she can direct the fund to pay $1,000 to her church, university, museum, theater, etc. after July 1 and this will be a qualified charitable distribution and is non-taxable. If the distribution occurs on June 30, it is taxable.
Suppose it’s already August and that the funds are still sitting untouched in Sieglinde’s old 401(k). Can she pay some of them to her favorite charity tax free? No. There are no qualified charitable distributions from a 401(k). Could she roll them over to an IRA invested in the same mutual funds and then make a qualified charitable distribution. Sure. Again, the order of operations matters.
You might try asking your tax adviser before you make any such distributions. When you’re having her do the return is too late. Paying to hear what you might have done is too painful. Order of operations matters.
Death and Taxes 