In 2017, I took an early withdrawal from my 401(k). I used a portion of this money to pay off a hospital bill that was in collections, but I did not make the payment until January 2018. Can I deduct the amount of this collections from the taxable portion of the 401(k) distribution from 2017?
Generally, there is a 10 percent early withdrawal penalty for 401(k) withdrawals before the age of 59.5. Also, the full withdrawal must be included in income in the year of the withdrawal to be subject to tax.
There is, however, an exception to the early withdrawal penalty for large medical expenses. The penalty will not apply to the withdrawal amount used for medical bills that exceeds 7.5 percent of adjusted gross income (AGI), regardless of whether a taxpayer itemizes deductions or not. Furthermore, if a taxpayer does itemize deductions, the excess of medical expenses paid over 7.5 percent of AGI is deductible from taxable income. To put it another way, there is no penalty relief or tax relief except on amounts over 7.5 percent of your AGI. So, it all depends on the medical expense amount, the withdrawal amount, and your AGI in the year in question.
Individual taxpayer’s report income and expenses to the IRS on a “cash” basis. In other words, the date of receipt or payment governs the year in which the event is reported for tax purposes. It’s therefore important, in this example, to plan to take the 401(k) withdrawal in the same year that the medical expense is paid. That did not happen. There is a good case to avoid the 10 percent early withdrawal penalty if the medical expense amount was over 7.5 percent of AGI in 2017. However, the medical expense deduction must be taken in the year paid (2018 in this case), subject to the taxpayer’s income and medical expense limitations in 2018.
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Answered by: Thomas N. Alvaré, CPA, is managing principal with JFS Wealth Advisors in Doylestown, Pa.