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PILLA TALKS TAXES - Prior Featured Article


 Exceptions and Exemptions to the "Individual Mandate"

by Daniel J Pilla  

Article originally found in Feb 2014 issue of Pilla Talks Taxes Newsletter*


As we all know by now, federal law requires all persons in the United States to maintain “minimum essential health care coverage” for themselves and their dependents beginning this year. See code §5000A. Failure to purchase such care will subject the individual to an annual penalty, which the statute refers to as a “shared responsibility payment.” Code §5000A(b). 

This provision of the Patient Protection and Affordable Care Act (Obamacare) is referred to as the “individual mandate” in that Congress has mandated that individual citizens purchase an insurance product that meets federal guidelines. Such a mandate is unprecedented in American law. There is no other example in U.S. history where the government required a person, as a matter of law, to purchase a specific product or service or risk civil penalties. 

The penalty is equal to the greater of:
     • $695 per person per year, up to a maximum of $2,085 per family, or


     • 2.5 percent of “household income.” Code §5000A(c). 

The percentage increase is phased-in over three years. Beginning in 2014, the percentage is 1 percent. Beginning in 2015, the percentage is 2 percent. For years after 2015, the percentage jumps to 2.5 percent. The gross applicable penalty is pro rated to apply on a monthly basis “for any month during which any failure” to have adequate coverage exists. Code §5000A(c)(2). The penalty amount must be computed by the taxpayer and reported on his tax return. 

In my Special Report I published on Obamacare, entitled “IMPLEMENTING NATIONAL HEALTH CARE: Taxpayers and IRS to be Challenged as Never Before,” (PTT, July 2012), I discussed this penalty and explained that the law contains both “exceptions” and “exemptions” to the penalty. Now that the IRS has issued regulations on this element of the law, it is time to elaborate on the “exceptions” and “exemptions” that allow one to avoid the penalty. Let’s us discuss each of them individually. 

1. Religious conscience exemption – §5000A(d)(2)(A). This provision holds that any member of a recognized religious group that has historically been exempt from Social Security taxes may also be exempt under Obamacare. Tax code §1402(g)(1) defines who is exempt for purposes of Social Security taxes and that definition applies to the penalty under Obamacare. 

Code §1402(g)(1) provides that a person can be exempted from Social Security taxes if he: 

a. Is a member of a recognized religious sect or organization, 

b. Is an adherent to the established tenets, teachings or beliefs of that sect or organization, and 

c. By reason of those beliefs, he is conscientiously opposed to accepting benefits under any private or public insurance policy that would make payments in the event of death, disability, old-age or retirement or makes payments toward the cost of, or provides services for, medical care. 

The exemption is honored only if it is established that the organization to which the person belongs actually has established teachings or tenets regarding the provision of insurance, that the organization has a long standing practice of providing for the needs of their members, and that the religious organization has been in existence at all times since December 31, 1950. Code §1402(g)(1)(C)-(E). 

To establish this exemption, you must provide a certification to the health care Exchange that proves you meet all of the above elements. See: Rev. Reg. §1.5000A-3(a)(2). The Exchange is then required to issue the certificate of exemption. For more on the Exchanges, see my report, “IMPLEMENTING NATIONAL HEALTH CARE.” 

A family with minor children that meets the requirements for exemption may also exempt their minor children. However, once a child turns age twenty-one, to maintain the religious conscience exemption, the child must reapply for the exemption and attest to membership individually. See: Treasury Decision 9632, §III.A.


2. Persons involved in a “health care sharing ministry” – §5000A(d)(2)(B). A health care sharing ministry (HCSM) provides a health care cost sharing arrangement among persons of similar and sincerely held beliefs. An HCSM is founded on the Biblical mandate of believers to share each other’s needs. The goal is to share the health care needs of others in order to meet the rising costs of health care. 

HCSMs are non-profit religious organizations acting as a clearinghouse for those who have medical expenses and those who wish to share the burden of those medical expenses. HCSMs receive no funding or grants from government sources. HCSMs are not insurance companies. HCSM do not assume any risk or guarantee the payment of any medical bill. Twenty-five states have explicitly recognized this structure and specifically exempt HCSMs from their insurance codes. According to the Alliance of Health Care Sharing Ministries, there are now over 210,000 people participating in these ministries in all fifty states.
Examples: See   or  Medi-Share    

Section 5000A(d)(2)(B)(ii) provides that an HCSM: 

a. Must be an established 501(c)(3) tax-exempt organization,  

b. Members must share a common set of “ethical or religious beliefs” and “share medical expenses among members” in accordance with those beliefs and without regard to where the member lives or works, 

c. Must have been in existence since at least December 31, 1999, 

d. The medical expenses of its members must have been shared “continuously and without interruption” since December 31, 1999, and 

e. Must undergo an annual audit by “an independent public accounting firm” and the results of the audit must be “made available to the public upon request.” 

The regulations require that a person establish his eligibility for the exemption on a monthly basis. That is, this appears not to be an annual exemption, but must be verified “for every month of that taxable year for which they seek exemption.” See: Treasury Decision 9632, §III.B; Rev. Reg. §5000A-3(b)(2).  

It seems that the IRS has put provisions in place to make the process for achieving exemption under this provision as arduous as possible. 

3. Persons not lawfully present in the United States – §5000A(d)(3). A person who does not have lawful immigration status is not obligated to have health insurance under the law. A person falls under this exemption if he either is: a) a nonresident alien, or b) is not lawfully present in the U.S. See: Rev. Reg. §1.5000A-3(c)(2). Thus, all the illegal aliens currently in the country have no duty under the law to have insurance. But how do they claim the exemption? The regulations provide no mechanism for doing so. I suppose they will do so that the same way they currently file their tax returns: not at all. Further IRS guidance will be issued on the topic in the future. 

4. Persons who are incarcerated – §5000A(d)(4). This section provides that an individual is exempt for a month when the individual is incarcerated (other than incarceration pending the disposition of charges). The regulations provide that an individual confined for at least one day in a jail, prison, or similar penal institution or correctional facility after the disposition of charges is exempt for the month that includes the day of confinement. 

5. Those who cannot afford coverage – §5000A(e)(1). The law exempts those who cannot afford minimum essential coverage. The exemption applies only on a month-to-month basis. That is, if a person cannot afford coverage for two of twelve months, his exemption applies only to those two months. 

Insurance is considered unafforable if the premium exceeds 8 percent of “household income.” Rev. Reg. §1.5000A-3(e)(2). This amount is indexed for inflation so is likely to increase annually after 2014. The amount of increase is determined by the Department of Health and Human Services based upon a ratio between income growth and insurance costs. 

In determining the “household income” for purposes of the 8 percent cap, you are required to include in your income any amounts withheld under a salary reduction agreement, or cafeteria plan provided by an employer. While these benefits are considered not taxable for federal income tax purposes, they are included in the calculation of “household income” for purposes of determining whether your insurance coverage is “affordable.” 

What is “household income?” The phrase “household income” is defined by Rev. Reg. §1.36B-1(e)(1). Generally, the phrase means the sum of: 

a. The taxpayer’s modified adjusted gross income (discussed below); plus 

b. The aggregate modified adjusted gross income of all other individuals who— 

1. Are included in the taxpayer’s family (as discussed below), and 

2. Are required by law to file a federal income tax return under code §6012. Generally, the requirement to file a tax return is tripped by the receipt of income in excess of the filing requirements expressed in §6012. 

 Now we have to define “modified adjusted gross income.” That phrase is held to constitute adjusted gross income plus: 

            a. Tax exempt interest the taxpayer “receives or accrues” during the tax year, 

            b. Any foreign earned income that otherwise would be excluded under code §911, and 

            c. Social Security benefits that were not otherwise includable in income under code §86. 

Finally, we have to define “family” for purposes of this discussion. The term “family” is defined in Rev. Reg. §1.36B-1(d) as follows: 

A taxpayer’s family means the individuals for whom a taxpayer properly claims a deduction for a personal exemption under section 151 for the taxable year. Family size means the number of individuals in the family. Family and family size may include individuals who are not subject to or are exempt from the penalty under section 5000A for failing to maintain minimum essential coverage. 

Thus, “household income” includes not only the taxpayer’s wage or business income, but it includes his tax-exempt interest, non-taxable Social Security benefits and non-taxable foreign earned income, plus all of the same income items of every person in his household for whom he claims a dependent exemption. That can include all children up to 24 years of age or a disabled child of any age, any relative that lives with you such as a parent or grandparent, brother, sister, etc., provided they qualify as your dependent exemption on your tax return. 

The 8 percent premium cap is figured on the basis of this “household income.” In many cases, it will be substantially more than the income reported on your tax return for the period in question. My question is who made the decision that the income of other persons is available to you to pay medical expenses? The 8 percent cap is based upon all the income of the household while it is probably the case that the income of third parties is just not available to cover medical bills. For example, if your seventeen year old son makes $4,800, that will raise your “household income.” However, none of his money is available to you because he spent it all on his car and girlfriend. 

6. Those with incomes below the tax return filing requirement – §5000A(e)(2). This section provides that a person is exempt if his “household income” for the year is less than the return filing requirement under code §6012(a). The problem here is that the filing thresholds under §6012 have nothing to do with “household income.” The filing thresholds are based solely (as they most certainly should be) on individual income, since the liability for return filing and tax payment is based solely on one’s individual income. 

Even in the case of a husband and wife, the requirement to file a tax return (assuming both had income) is an individual responsibility. Married couples have the option to file a joint income tax return, but that is a voluntary election that must be made by both spouses on the return itself. Only then can one spouse be held liable for the tax owed by the other spouse. Under no circumstances can the IRS force a married couple to file a joint income tax return. 

The regulations shed no light on how this discrepancy is to be reconciled. Rev. Reg. §1.5000A-3(f)(2)(ii) simply states: 

The applicable filing threshold for an individual who is properly claimed as a dependent by another taxpayer is equal to the other taxpayer’s applicable filing threshold. 

I’m sorry to say I don’t know what that means. As near as I can tell, the determination of a filing requirement is based upon the income of all family members, added together, then applied to the code §6012 threshold amounts. Thus, a person may not have a filing requirement based solely on his personal income. But he may have a “filing requirement” when his “household income” is calculated. And while that “household income” may not then actually trip a tax return filing requirement, it would kick that person out of the exemption provision of this section. Anyway, that’s my guess. God help us. 

7. Members of an Indian tribe – sec 5000A(e)(3). Any person who is a member of an Indian tribe is exempt during the period of his membership.     

8. Those with “short coverage gaps” – sec 5000A(e)(4). A “short coverage gap” is defined as: 

…a continuous period of less than three months in which the individual is not covered under minimum essential coverage. If the individual does not have minimum essential coverage for a continuous period of three or more months, none of the months included in the continuous period are treated as included in a short coverage gap. Rev. Reg. §1.5000A-3(j)(2)(i). 

Thus, your coverage gap must be less than three months during the year. There is no partial exemption if your coverage gap exceeds two months. Moreover, the coverage gap “is determined without regard to a calendar year in which months included in that gap occur.” Rev. Reg. §1.5000A-3(j)(2)(iii). Thus, if you have a coverage cap in December of 2014 and January – February of 2015, you have three months of gap in coverage and may be subject to the penalty. 

9. Those with a hardship waiver – §5000A(e)(5). A “hardship” waiver certificate is issued by the Exchange to the individual and certifies that the person “has suffered a hardship affecting the capability to obtain minimum essential coverage.” Rev. Reg. §1.5000A-3(h)(2). The term “hardship” for this purpose is not defined in the Internal Revenue Code. Rather, it’s in the heath care regulations, at 45 CFR §155.605(g). 

The application for a hardship waiver must be made to the Exchange based upon the forms and procedures offered by the Exchange. The hardship waiver applies if the Exchange determines that the individual: 

a. Experienced financial or domestic circumstances, including an unexpected natural or human-caused event, such that he had a significant, unexpected increase in essential expenses that prevented purchasing coverage under a qualified health plan, 

b. Would have experienced serious deprivation of food, shelter, clothing or other necessities due to the expense of purchasing a qualified health plan, or 

c. Experienced other circumstances that prevented purchasing coverage under a qualified health plan. 45 CFR §155.105(g)(1)(i) - (iii).

 The hardship waiver is determined by the Exchange based upon the individual’s “projected annual household income.” Moreover, the individual’s eligibility for an employer-sponsored plan is also considered. Ibid, at §(g)(2). 

As discussed in more detail in the following article, there have been many delays in implementing and enforcing Obamacare. Both the employer mandate and individual mandates have been pushed back. Thus, the penalties are not currently being enforced. Because this issue continues to be in a state of massive flux, I will stay on top of it as necessary.



 March 2017 Update:

            Link to Affrodable Care Act Instructions for  Form 8965 (2016)  

Article taken from February 2014 T  issue of "Pilla Talks Taxes."  

*Portions modified  March 2017



Dan Pilla' monthly newsletter, Pilla Talks Taxes, features news stories and developments in federal taxes that effect your pocket book. Each information packed issue shows you how to use little known strategies to cut your taxes, protect yourself from the IRS, exercise important taxpayers' rights and keeps you up to date on the latest trends in Washington on the important subjects of taxes and your rights. You can't afford to miss a single issue!

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PILLA TALKS TAXES - Featured Article


 Simple Signs That You May be Targeted by Scammers 

It is for your defense and protection that I offer the Five Things Every Citizen Needs to Know About IRS Contacts. If you know and understand these five rules about how the IRS deals with the public, you will never be victimized by a phone call, e-mail or text message scam. Pay close attention to what I say here. 

In its interactions with the public, the IRS will NEVER  

1. Use e-mail or text messages for any reason. This is true whether the IRS is gathering needed information to process your return, to notify you of a tax audit, or to follow through with the collection of a delinquent tax. Even in cases where you have an ongoing relationship with a given IRS official, such as occurs in tax audit cases that might take many months to resolve, they will not do business through e-mail or text messages. The IRS will allow you to fax information to them (in which case a fax number will be provided either in writing or verbally from the agent personally) but the IRS will not interact through e-mails and text messages. If you think you owe the IRS money but are not sure, obtain your IRS transcripts directly from the agency. You can call the IRS’s Automated Collection Service directly at 800-829-1040 to do so, or consult counsel who can do so. That way, you’ll know precisely what you owe, if anything, and for which years. 

2. Call a person in the first instance while in the act of collecting taxes. In most cases, the calls made by scammers purporting to collect taxes are the first form of contact or notice that a person allegedly owes taxes. This will NEVER happen. If the IRS decides that you owe taxes without first conducting an audit (which is very possible and happens often), the agency will notify you in writing in the form of some kind of correction notice. See: The IRS Problem Solver. You have the right to respond and object to any such notice. If you are engaged in an audit, the case must be finalized before theres any assessment of tax liability. In that situation, you will discuss the matter with the auditor and potentially his manager and even an Appeals Officer if you decide to challenge the preliminary decision. See: How to Win Your Tax Audit. All of this happens well before any demand for payment is ever made. It is possible to deal with a tax collector, known as a Revenue Officer, via the phone. But even in that situation, such phone contact occurs only after a series of written notices and letters have been sent. Any letter sent by a Revenue Officer will give you his name and contact information, including a fax phone number. And the Revenue Officer will be based in a local IRS office, not some place in Washington because “the case was transferred.” In NO CASE will you be contacted by phone in the first instance by an actual IRS employee demanding payment in forceful and intimidating terms. 

3. Threaten to file a lawsuit if taxes arent paid today. If you have been delinquent on your taxes for more than a decade, AND if you have failed to respond to all the IRSs collection notices, AND if youve been working with specific tax collectors for years but have failed to pay, make arrangements to pay, or otherwise manage your tax delinquency, AND you have substantial equity in assets, it is POSSIBLE (though not LIKELY) that the IRS will sue you to obtain a judgment. This is a so-called section 7403 action, which I discuss in my book, TaxpayersDefense Manual. In such a suit, the IRS seeks to reduce its assessment to a judgment and then execute that judgment against your property. Chiefly, the IRS uses this tool to reach the equity in your personal residence because the agency is not allowed to seize your main home through administrative collection action. See: How to Get Tax Amnesty for my discussion of all assets and income that are exempt from IRS levy. Having said that, the IRS will NEVER call you on the phone (especially in the first instance; see point 2 above) to threaten a lawsuit. Even in cases where you have done one or more of the things I list in the first sentence of this paragraph, the IRS will NEVER call you to say that unless you pay x amount today, they will file a suit. Such discussions may possibly (but not likely) come up in your conversations with the Revenue Officer, but again, this will NEVER come in the form of a phone call from somebody youve never had contact with in the past. 

4. Demand that taxes be paid in a certain way. Even if you do owe taxes, and even if you are dealing with a Revenue Officer, and even if youve been interacting with that officer for some time, the IRS will NEVER demand that you pay taxes in a certain manner or by using a specific procedure—and most certainly will not take payment in the form of gift cards or PayPal credits! Moreover, the IRS will NEVER ask for debit or credit card numbers over the phone. For example, the IRS will not state that you must pay by debit card or wire transfer, and then ask you for the debit card number. You have the right to pay your taxes in any manner that you want, and at any IRS office thats convenient to you, including using the IRSs electronic payment system (EFTPS) on its web site. A sure sign of an absolute scam is a demand that you go to your bank “right now” to wire-transfer money, or to purchase a gift card. In fact, the IRS cant even take a payment via credit or debit card over the phone. To make a payment in such a fashion, you must go online to the agencys EFTPS system. Even in the case of a Direct Debit Installment Agreement (where the money is taken in monthly payments automatically from your bank account), this must be set up either with a Revenue Officer, Appeals settlement officer (through a Collection Due Process appeal), or the IRSs ACS toll-free phone numbers. The very fact that youre being asked to pay in a certain way right now—today—over the phone—is absolute proof of a scam. 

5. Threaten to arrest you if dont pay taxes today. People are naturally frightened by the IRS and are quite frightened by the idea of going to jail. And while it is certainly true that some people will end up in jail over their dealings with the IRS, the fact is, you have a better chance of being eaten by a shark than you do of going to jail for a tax crime. Thats why I have an entire chapter in my book, How to Get Tax Amnesty, entitled, “Am I Going to Jail?” In that chapter I make it perfectly clear exactly what kind of person runs the risk of going to jail and why. And even if you fit the profile described there of a person at risk of going to jail, the IRS will NEVER call you on the phone (especially in the first instance) and tell you that if you do not pay a certain amount of taxes right now, using a certain method of payment (see paragraphs 2 and 4 above), they will send a sheriff or the police out to arrest you immediately. If you are targeted for a criminal investigation, the IRS will contact you in person, in the form of a visit from two (not one) Special Agents. These are the IRSs criminal investigators. They will read you your “Miranda” rights, explaining that you have the right to counsel and that anything you say will be used against you. That is absolutely not going to happen over the phone. 


Keep these five rules in mind, and you will never be robbed by IRS impersonators. 

Article taken from February 2017 THE TAX SCAM Special Report  issue of "Pilla Talks Taxes."



Dan Pilla' monthly newsletter, Pilla Talks Taxes, features news stories and developments in federal taxes that effect your pocket book. Each information packed issue shows you how to use little known strategies to cut your taxes, protect yourself from the IRS, exercise important taxpayers' rights and keeps you up to date on the latest trends in Washington on the important subjects of taxes and your rights. You can't afford to miss a single issue!

An email address is needed to recieve this newsletter.  MORE INFO

10 issues per year. $99.00 per yr Order Now!






Procedure May Help Clean Up the Mess



The Latest Wave of Cyber-theft Pointed at Accountants and Tax Preparers



Summary of the Most Recent Schemes Afoot



Simple Signs That You May be Targeted by Scammers






PILLA TALKS TAXES - January 2016 Featured Article

 IRS To Limit How Much It Will Seize

A common question with delinquent citizens is whether the IRS can levy social security benefits. The answer, unfortunately, is yes they can, and worse, they do so regularly. Before intercepting an SS payment, the IRS generally sends notice CP91, Final Notice Before Levy On Social Security Benefits. This letter informs you of the impending levy and invites you to call the IRS to set up payments if you cannot pay in full.

Please understand that CP91 is not a substitute for a Final Notice, Notice of Intent to Levy and Notice of Your Right to a Hearing. That is the notice required by law under §§6330 and 6331, before the IRS can levy any assets or income whatsoever. The IRS uses Letter 1058 and notice LT11 as the Final Notice. The notice gives you the opportunity to request a Collection Due Process hearing before any levy action goes forth.

The CP91 notice is generally mailed well after a Final Notice was mailed. A notice CP91 does not carry CDP rights. Therefore, upon receipt of a CP91, you must take steps to avoid levy on your SS income apart from filing a Request for CDP hearing. See chapters 5 and 11 of How to Get Tax Amnesty for more details. 

Internal Revenue Code §6331(h) is the statute that provides authority for an ongoing levy on Social Security payments. Paragraph (1) reads in pertinent part:

If the Secretary approves a levy under this subsection, the effect of such levy on specified payments to or received by a taxpayer shall be continuous from the date such levy is first made until such levy is released. Notwithstanding section 6334 [which sets forth exemptions to levy], such continuous levy shall attach to up to 15 percent of any specified payment due to the taxpayer. Emphasis added. 

Paragraph (2) then begins: 

For the purposes of paragraph (1), the term “specified payment” means— 

(A) any Federal payment other than a payment for which eligibility is based on the income or assets (or both) of a payee, ... (Emphasis added.)

Thus, payments under any SS program are clearly covered by this levy provision. Typically, such levies are carried out under the Federal Payment Levy Program (FPLP). This is an automated levy program the IRS implemented in 2000 in cooperation with the Department of the Treasurys Bureau of Fiscal Service (formerly the Financial Management Service).

Every week the IRS sends to the BFS a file identifying delinquent taxpayers. The BFS matches the names on the list against recipients of federal payments, including Social Security payments. (Though the SSA is an independent agency of the U.S. Government, the Department of the Treasury makes its payments.) After a match is made, both the IRS and the BFS send a notice to the taxpayer that the IRS will start levying 15% of the payment. The IRSs notice is the CP91 mentioned above. 

Many have argued that code §6331(h) actually limits the IRS to levying no more than 15 percent of ones SS benefits, but this is just not true. As an alternative to using the FPLA, the IRS could levy up to 100 percent of your SS benefits through the levy procedure set forth in code §6331(a). That section requires action by a revenue officer, as opposed to an automated levy. Such a levy would continue at up to 100 percent until you argue for the allowed levy exemptions expressed in code §6334(a)(9), or a release of levy under code section 6343 (levy causing a hardship). The table at provides the levy exemption amounts for 2016 that are applicable to any levy. For more details on the 100 percent levy issue, see the article “Can the IRS Levy 100% of a Taxpayers Social Security Benefits?” by Paul Tom, PTT, Oct-Nov, 2014. 

Despite the fact that the IRS is legally authorized to levy 100 percent of ones SS benefit payments, the agency recently issued administrative guidance limiting certain SS levies. In Field Collection memoranda SBSE-05-1015-0067, October 7, 2015, the IRS announced that it will no longer subject Social Security disability insurance payments to levy via the automated FPLP. The change applies to payments made after October 3, 2015.

Please note this is a policy change only. It is not a statutory or regulatory change. Moreover, the policy applies only to SSDI payments. It does not apply to SS retirement income benefits. The Social Security Administrations “Program Operations Manual Systems GN 02410.305” confirms that beginning October 2015, the IRS and the Treasury will exclude SSDI payments from the FPLP. 

This article is found in Dan's January 2016 issue of Pilla Talks Taxes. 


Dan Pilla' monthly newsletter, Pilla Talks Taxes, features news stories and developments in federal taxes that effect your pocket book. Each information packed issue shows you how to use little known strategies to cut your taxes, protect yourself from the IRS, exercise important taxpayers' rights and keeps you up to date on the latest trends in Washington on the important subjects of taxes and your rights. You can't afford to miss a single issue!

An email address is needed to recieve this newsletter.  MORE INFO

10 issues per year. $99.00 per yr Order Now!



       How To Get Tax Amnesty Chapter 1:
PArtial Pay Installment Agreements Excerpt

       Tax Court Addresses Interest Abatements and Abuse of Discretion   

IRS To Limit How Much It Will Seize

       2016 Numbers Announced

       Dan Pilla Answers Readers' Questions 





PILLA TALKS TAXES - October 2016 Featured Article


 The Tax Consequences of Taking Your 401(k) or IRA

Below are portions taken from the article WHAT EVERY CITIZEN NEEDS TO KNOW ABOUT RETIREMENT FUND DISTRIBUTIONS found in my October 2016 issue of Pilla Talks Taxes. The full article is available to Pilla Taks Taxes subscribers.  More information on how you can become a subscriber.


I can’t count the number of times people have told me that the reason for their delinquent tax debt is that they took a retirement fund distribution and didn’t realize the extent to which it was taxable. They might claim that “withholding” was taken from the distribution which they “thought was enough to pay” what they would owe. As it turns out, that was not the case. Often, no taxes whatsoever were paid on the distribution. 

In one case, my clients took out about $350,000. The plan administrator withheld 20% for federal taxes (absent specific instructions from the client), and sent the remaining balance—about $280,000—to the clients. They then used the money for all manner of spending. They made substantial repairs to one child’s home. They spent money on an elaborate vacation for the kids and grandkids (about twelve in all). And, they paid off substantial credit card debt for themselves and their kids. At the end of the spree, the money was gone—all of it. 

When their tax return was completed the following spring, they experienced the worst kind of sticker shock. As it turned out, the 20% withholding of about $70,000 was well under the federal income tax hit, which alone was about a third of the total distribution, not to mention the state tax obligation on top of that. Considering that the early withdrawal penalty (if applicable) on a typical retirement plan distribution is 10% by itself, the $70,000 of withholding was less than half the total tax on the distribution. 

Why did this happen? And why does it happen so often? 

It happens because too many people simply do not understand the essential tax consequences of funding and liquidating IRA and 401(k) retirement plans. For this reason, a more detailed discussion of these concepts is in order. 

Tax-free or Tax-deferred? 

Many people are under the impression that their retirement plan distributions are tax-free. In most situations, that is just not the case. For example, in the case of a typical IRA or 401(k) plan contribution, the retirement plan is tax-deferred, not tax-free. When I say the plan is tax-deferred, I mean that the tax consequences are not eliminated. Rather, they are put off until some future date. 

Here’s how the system works. Under ordinary circumstances, when you are paid $1,000 as compensation for services, the money is taxed in the year you earn it. If you pay taxes in the 25% bracket, the $1,000 carries a federal tax burden of $250, leaving you with after tax income of $750. Now suppose you invest the $750 in some kind of investment portfolio. All of the investment earnings, whether capital gains, interest or dividends, are likewise subject to tax based upon the nature of the income and your tax bracket. 

Now suppose that you deposit the same $1,000 into your IRA retirement account. At that point, the $1,000 is an adjustment to your income. That is, you get a deduction for the money in the year it is deposited to the account. That saves you $250 in taxes in the year of the deposit. Moreover, as the $1,000 earns investment gains over the years, those gains are also not subject to tax in the year of the gain as long as the gain remains invested in the IRA. 

So far, so good. But this is often the point of confusion. People often believe that because there’s no tax on the gains as they are earned over time, and because they got a deduction for the initial contribution at the time it was made, the account is somehow not taxed at all. And this is the source of the confusion between the concept of tax-free and tax-deferred

Tax-free means there is never any tax on the transaction. An example would be the proceeds of a gift or inheritance. These items are never taxed to the recipient. If you get a gift from your mother of $10,000, that gift is never taxable to you. It may be subject to a gift tax owed by your mother, but it’s not taxable to you as the recipient. 

On the other hand, as stated above, tax-deferred means that the tax is put off to some future date. The transaction is not free of tax, but rather, the tax is imposed at a later date based on actions that trip a tax obligation. 

IRA and 401(k) Contributions 

IRA and 401(k) gains and distributions are tax-deferred. You get a deduction for the contribution in the year it goes into your account (subject to certain limitations). As such, the contribution is not subject to tax in that year. However, when you take the money out of the account as a distribution, the money is taxed as ordinary income in the year of the distribution. By that I mean the distribution is treated as if it were wage income in the year of the distribution. 

As such, a $350,000 IRA distribution in a given year is taxed in that year as if the taxpayer received $350,000 of wage income from his employer. Even without regard to the actual wage income received during the year, the $350,000 would be at least partially subject to the 33% tax bracket. (Because the tax rates are marginal, the 33% bracket applies to income over $231,450 but under $413,350 in 2016). 

Early Withdrawals  (see full article)

Exceptions to the 10% Early Withdrawal Penalty  (see full article)

Get help with Retirement Plan Distributions  

 “Why didn’t the IRA people tell me that?” 

This is a question I hear over and over as people learn about the tax and penalty consequences of a retirement plan distribution. The answer is I don’t know why they didn’t tell you. I believe a common reason is that you, as the taxpayer, may not have asked the right questions, or in many cases, didn’t ask any questions at all. 

And more likely, I don’t believe retirement plan people ever stop to think whether you have balanced out all the consequences of taking the money. After all, it is your money and you can do what you want with it. Nobody, including the IRS, can stop you from taking a distribution for any reason you like—or for no reason at all. You simply have to pay the price when you do. 

The better questions to ask are, “What have you done to educate yourself about the consequences of a withdrawal?” And knowing the consequences, “Have you properly provided for payment of the tax liability that grows from the distribution?” 

You are responsible to know the consequences of a retirement plan distribution and to provide for the payment of the tax from the proceeds of the distribution. The IRS has resources available to help with this. Three specific publications discuss retirement plans generally, retirement plan contributions, and retirement plan withdrawals. These include IRAs and 401(k)s. The publications are: 

            Publication 590, Individual Retirement Arrangements

            Publication 590-A, Individual Retirement Arrangement Contributions

            Publication 590-B, Individual Retirement Arrangement Distributions 

All of these publications are available on the IRS’s website, which is 

Beyond the IRS’s publications, there is no substitute for good counsel from a tax pro who is educated and experienced in the specific area of concern. It is always best to consult counsel before you take any action so that you can be guided in how to identify and handle the anticipated consequences. If you wait until after you take action to consult counsel, the advice very often at that point amounts to nothing more than damage control. 


Consulting Members of my Tax Freedom Institute can help with these and other tax planning and enforcement issues.
To contact the Consulting Member nearest you, Click Here,


Article taken from October 2016 issue of "Pilla Talks Taxes."



Dan Pilla' monthly newsletter, Pilla Talks Taxes, features news stories and developments in federal taxes that effect your pocket book. Each information packed issue shows you how to use little known strategies to cut your taxes, protect yourself from the IRS, exercise important taxpayers' rights and keeps you up to date on the latest trends in Washington on the important subjects of taxes and your rights. You can't afford to miss a single issue!

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October 2016



The Tax Consequences of Taking Your 401(k) or IRA

Understanding the "Required Records Exception"
by Scott MacPherson, Attorney at Law





PILLA TALKS TAXES - July 2015  Featured Article

"I'M FROM THE IRS...  And You're Going to Jail!"


According to a June 25 report from the Treasury Inspector General for Tax Administration, the watchdog agency gets roughly 12,000 calls a week to its fraud hotline. The reason, says Inspector General Russell George, is because of the “largest, most pervasive IRS impersonation scam in the history of this agency.”

 This is the scam I wrote about in recent issues of this newsletter and which I discuss extensively in my new book, How to Win Your Tax Audit. A caller telephones a target, claims to be from the IRS and makes outrageous claims that the target will be arrested and will go to jail within the next day if he does not pay delinquent taxes immediately using a credit card. Believe it or not, just within the last week, my son received such a call and I even got one at my home phone number.

Incredibly, the scam works—or at least it works often enough to keep the scammers in business. According to George, “More than 3,300 taxpayers have lost a reported $16.8 million to these criminals, who fraudulently claim to be IRS officials.” He went on to say in his statement that “the federal tax systems integrity has never been more challenged.”

Why Cant the IRS Shut These People Down?

Thats a simple question but the answer is not so easy. For one thing, they operate offshore. They are not U.S. citizens and frankly, they have very little practical knowledge of IRS procedures, which is painfully evident when you hear one of their phone messages, or talk with them, as I have done several times. Somehow they bounce their calls through U.S. phone lines so that ones caller ID shows a U.S. phone number as the incoming line (usually from a Washington, D.C. area code) and the return phone number for calling back is also to a U.S. number.

“Because of the complexity of their operations, scams such as these are not typically resolved quickly,” George said. That could be the understatement of the year. TIGTAs Office of Investigations is working to identify perpetrators. However, I cant imagine that much progress will be made when compared to the sheer volume of calls these criminals make. It seems like everybody is getting these calls. And since the criminals are operating offshore, how would you prosecute them, even assuming you could be a case against them?


Dont forget that the easiest thing in the world to say to any caller who makes any kind of legal claim against you, as I state in How to Win Your Tax Audit, is “put it in writing.” Dont ever respond over the phone to demands for information or money, especially from someone claiming to be from the government.


This article was part of the July 2015 issue of  Dan Pilla's monthly electronic newsletter, Pilla Talks Taxes.





Dan Pilla' monthly newsletter, Pilla Talks Taxes, features news stories and developments in federal taxes that effect your pocket book. Each information packed issue shows you how to use little known strategies to cut your taxes, protect yourself from the IRS, exercise important taxpayers' rights and keeps you up to date on the latest trends in Washington on the important subjects of taxes and your rights. You can't afford to miss a single issue!

An email address is needed to recieve this newsletter.  MORE INFO

10 issues per year. $99.00 per yr Order Now! Copyright © 2015 Winning Publications. All rights reserved. Call us at 1 800-553-6458