5 Things To Know About Disability Exception to 10% Early IRA Distribution Penalty

By Jeffery Levine, IRA Technical Expert  
Follow Me on Twitter: @IRAGuru4EdSlott

Retirement funds, like the money in your IRA, should generally be preserved for use in your retirement. This is not exactly a novel concept, but one that often bears repeating. That being said, sometimes events happen beyond your control that might require you to access your retirement funds before you intended. If you happen to be younger than age 59 ½, then your distributions could not only be hit with income tax, but a 10% penalty.

There are, however, a number of excuses, more formally known as exceptions, that you can use to get out of the 10% penalty and lessen your tax burden. One such exception is for disability. Below, we discuss five important facts you need to know about this exception if you plan on trying to use it to avoid the 10% penalty.

1) This Exception Applies To Plans and IRAs
Some exceptions to the 10% penalty only apply if your distribution comes from an IRA. Others apply only to distributions from a plan, like a 401(k). The disability exception, however, is one of a handful of exceptions that you can use to get out of the 10% penalty regardless of what type of retirement account your distribution is coming from.

2) It Must Be Your Disability if it’s Your Retirement Account
Some exceptions to the 10% penalty allow you to take other family members into consideration when you take a distribution. For instance, the higher education exception to the 10% penalty can be used when you have higher education expenses, but it can also be used to help pay for a spouse’s, child’s or even grandchild’s higher education expenses. In contrast, if you plan on using the disability exception to the 10% penalty, you must be disabled and the distribution must come from your own account. You cannot use another family member’s disability to claim the exception for distributions from your own retirement account.

3) You Must Be Really Disabled
In order to claim the disability exception to the 10% penalty, the tax code says that you must be unable to do any work and the disability is going to be of indefinite duration or is likely to result in death. That’s a pretty strict definition. It is not having to change careers as a result of an injury or even “retiring on disability” if you are still able to work in another capacity. If you can still work in some “substantially gainful” way, you aren’t disabled enough, per the tax code, to claim the disability exception.

4) Your 1099-R Will Still Indicate the 10% Penalty Is Owed
When you take a distribution from a retirement account, the account’s custodian sends you (and IRS) a 1099-R to report your distribution. In addition to showing the amount of the distribution, there’s a box (box 7) on the 1099-R that discusses the type of distribution. There is a code (code 2) that indicates there’s a known exception to the 10% penalty and the distribution is not subject to this additional tax, but don’t count on seeing it on your 1099-R if you’re planning on claiming the disability exception. Custodians are not generally in the business of determining whether or not you’re disabled, and if you are, how disabled you are. So chances are, any 1099-R you receive will show a code 1 in box 7, which means that there is no known exception to your distribution. That means it’s up to you to tell IRS the 10% penalty doesn’t apply.

5) You Get Out Of The Penalty By Completing Form 5329
And how do you tell IRS the 10% penalty doesn’t apply to you because you are disabled? Simple, you file IRS Form 5329 with your tax return. Along with properly completing the form, you should submit at least one signed letter from a licensed physician attesting to the severity of your disability. That will generally satisfy any questions IRS might otherwise have. Remember, just as your custodian is not really equipped to say how disabled you are, neither is IRS. So if you can proactively provide appropriate evidence from a doctor, it’s usually enough to satisfy IRS that you are, in fact, disabled enough to claim the exception.