Disability and the Exception to 10% Early Distribution Penalty

Friday, October 07, 2016

By Beverly DeVeny, Chief IRA Analyst 
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Distributions taken from an IRA before attaining the age of 59 ½ are generally subject to an early distribution penalty of 10% of the taxable amount of the distribution. Congress put the penalty in place to deter IRA owners from using their funds before their retirement. However, Congress also realized that sometimes we really do have a need for these funds so they made some exceptions to the penalty.

One of these exceptions is the disability exception. But there is a catch. Many people, both advisors and IRA owners alike, think that if they are receiving any sort of disability payment that they will qualify for this penalty exception. Unfortunately, that is not true.

The definition of disability for the exception to the penalty is a very narrow one. The individual must be unable to perform any substantially gainful employment and the disability must be of long-standing or indefinite duration, possibly ending in death. The definition does not say you must be receiving disability payments, and it does not say that you must not be able to perform your “normal” job. Basically, you can’t be able to work at all.

If you qualify for this exception to the penalty, the good news is that there are no restrictions on how you use the IRA funds. You can pay bills, buy groceries, or take a vacation. The funds are not totally free, though. You will still owe income tax on the pre-tax funds withdrawn from your IRA.

There are no forms to file to show you are disabled, but if IRS questions your claim of an exception to the penalty, you will have to prove that you meet the definition of disabled. It is likely that your IRA custodian will issue a 1099-R showing an early distribution with no known exception to the penalty. You can’t blame them for this. They do not want to be in the business of determining the extent of your disability. To resolve this discrepancy, you will have to file Form 5329 with your tax return and note that you are using the disability exception to the penalty.

One other thing to note about this exception to the early distribution penalty is that it only applies to the disability of the IRA owner. If the spouse or a dependent of the IRA owner is the one with the disability, the penalty will apply. 

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