When folks become physically or mentally ill and unable to work, retirement plans are one of the first places they think of when looking for ways to replace their income. But if you take a distribution from a retirement plan before you turn 59 ½, you'll get hit with a 10% early distribution penalty -- on top of the regular income tax you may owe on the distribution.
Fortunately, the IRS gives a break to those who are totally and permanently disabled. Individuals with qualifying disabilities get an exception from the 10% early distribution penalty for all distributions.
The exception applies to the early distribution tax for IRA plans, 401(k) plans and other qualified plans, and SEP, SIMPLE IRA, and SARSEP plans.
To qualify, you must meet the IRS's definition of totally and permanently disabled. The IRS defines disability as an inability to perform substantial gainful activity (more than an insignificant amount of work) because of an identifiable physical or mental impairment that is expected to be of "long-continued and indefinite duration."
The IRS will want to see a doctor's opinion that you will be totally disabled permanently or for a long period of time and will want you to have this statement in your possession or in your medical records at the time you take the exception on your tax return.
The IRS's definition is very similar to Social Security's definition of disability – which also requires the inability to do substantial work -- except that Social requires your inability to work to last just one year. Therefore, having been found disabled for Social Security disability or SSI purposes does not guarantee the IRS will allow you to use the disability exception to the 10% penalty, but it can help, particularly if Social Security has classified your condition as "Medical Improvement Not Expected (MINE)." If, when your initial award letter came from Social Security, it said your case would be reviewed in five to seven years, you were classified as MINE.
The IRS's definition of permanent and total disability is also similar to the Veterans Administration (VA) rating for a veteran who has been deemed 100% disabled "based upon individual unemployability" (TDIU). But again, having a 100% TDIU rating does not force the IRS to find you eligible for the exception to the early distribution tax.
The definitions of disabled found in most long-term disability (LTD) plans are a bit different. Many LTD plans find you disabled if you are unable to do your own occupation. Obviously, the IRS's definition of disability is much harder to meet than this definition. However, if your LTD insurance provider has found you unable to do "any occupation," rather than just your own occupation, it's more likely you would be found disabled by the IRS.
Whether you or not you've been found disabled by another agency, you'll still to submit evidence from your doctor, written before you take the distribution, that, in your doctor's opinion, you are unable to work due to a physical or mental disability and that you will continue to be unable to work permanently or at least for a very long period of time. Once you have that medical opinion, you file an extra tax form with the IRS.
To claim the exception, when you submit your return, you need to file IRS Form 5329. Where it asks for the code to the exception, you enter code 03 for disability. (If you received a 1099-R form from your retirement plan administrator, look at box 7, "distribution code." If it has an 03 in it, your distribution was classified correctly.)
It makes sense to consult with a CPA prior to claiming an exception to the early distribution penalty on your tax return – or better yet, hire one to do your tax return the year you take an early distribution.
This exception is laid out in the Internal Revenue Code at 26 U.S.C. 72(t)(2)(A)(iii).