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The U.S. Court of Federal Claims recently denied a taxpayer's attempt to avoid the retroactive application of the 10% premature distribution penalty to a distribution taken from his conversion Roth IRA (Kitt v. U.S, No. 99-316T (Fed. Cl. 10/6/00)). Taxpayer claimed the retroactive imposition of the penalty violated both the U.S. Constitution's Due Process and Just Takings clauses of the Fifth Amendment, and constituted an excessive fine in violation of the Eighth Amendment.

The Loophole

Roth IRAs were established by the Taxpayer Relief Act of 1997 (TRA '97). In addition to providing that "qualified Roth distributions" would not be includible in gross income, the Act also allowed for the conversion of traditional IRAs to Roth IRAs. The amount converted would be included in the taxpayer's income, but the 10% early withdrawal penalty would not apply to the conversion itself.

Under the original statute, Congress inadvertently created a tax loophole. Taxpayers were permitted to convert traditional IRAs to Roth IRAs and to then take immediate distributions from their Roth IRA without paying the 10% penalty, as long as the distribution did not exceed the converted amount. Tax experts correctly advised the IRS that as written, the law in effect allowed taxpayers younger than 59 1/2 to access their traditional IRAs without suffering the premature withdrawal penalty.

On December 12, 1997, IRS issued interim guidance (Announcement 97-122, 1997-50 IRB 63) advising that the House had passed legislation closing this loophole that, when enacted, would be retroactively effective to January 1, 1998. On July 22, 1998, Congress enacted the IRS Restructuring and Reform Act of 1998 (IRSRRA '98) adding code section 408A(d)(3)(F). Under this section, distributions of Roth conversion contributions made within 5 years of the contribution, would be subject to the 10% early withdrawal penalty.

The Kitt Case

Mr. Kitt funded his Roth IRA in March, 1998, via a $69,059 conversion rollover contribution from his traditional IRA. This amount was included in his 1998 taxable income. In April 1998, Kitt withdrew $53,000 from the Roth IRA - a nonqualified distribution (both because he was younger than 59-1/2 and 5 years had not yet passed from the time of his first Roth contribution).

In February 1999, Kitt and his wife filed their joint income tax return reporting the $53,000 distribution and submitting $18,615 for the payment of unpaid taxes. $5,300 of the amount remitted was meant to pay the 10% premature penalty on the $53,000 distribution.

In May 1999, Kitt sought a refund of the $5,300, filing a complaint in the U.S. Court of Federal Claims. The Court dismissed Kitt's case and granted the IRS' motion for summary judgment:

No Due Process Violation - The court cited Supreme Court precedence that holds that the retroactive application of tax legislation does not violate the Due Process clause, further noting those provisions of IRSRRA '98 that retroactively applied the premature penalty tax to non-qualified Roth distributions were rationally related to the legitimate governmental purpose of curing Congress' mistake and recouping tax benefits conferred. The court also held the one year retroactive application of the legislation was "modest" in length and complied with customary congressional practice in such matters.

Takings Clause - The court ruled applying the premature distribution penalty did not violate the Takings Clause because the penalty does not fit within the meaning of "property," as contemplated by the Takings Clause.

Excessive Fines Clause - The court found that because the premature distribution penalty was not a punishment, it could not constitute of violation of the Excessive Fines Clause.

Last Updated: 12/15/2002 11:49:00 AM