The Disability Exception to the Early Distribution Penalty Tax for Retirement Accounts

When people 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 might owe on the distribution.

Fortunately, the IRS gives you a break if you're totally and permanently disabled. If you have qualifying disabilities, you don't have to pay the 10% early distribution penalty for all distributions you take.

Who's Eligible for the Exception to the Early Distribution Penalty?

The exception applies to the early distribution tax for the following:

• IRA plans
• 401(k) plans
• other qualified retirement plans,
• 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 any substantial gainful activity (more than an insignificant amount of work) because of a physical or mental impairment that's expected to be of "long, continued, and indefinite duration" (or to result in death) (see IRS Publication 590-B).

The IRS requires you to have a doctor's opinion saying you're totally disabled and will remain disabled permanently or for a very long time. But you don't have to submit your doctor's statement with your tax return. You just need to have it in your possession when you take the exception on your tax return.

How the IRS's Definition of Disabled Compares to Other Definitions

The IRS's definition of disability is similar to the definitions used by Social Security and the VA. But there are some differences.

Social Security's Definition of Disability

The IRS's definition of disability first appears to be quite similar to Social Security's definition of disability, but the IRS's definition is easier to meet in one way and harder to meet in another way. Both definitions require that you're unable to perform "any substantial gainful activity."

IRS regulations (26 C.F.R 1.72-17A(f)) clarify that "gainful activity" refers to the type of work you were doing before becoming disabled. The IRS will examine whether your impairments prevent you from engaging in your customary work activity or any work activity comparable to it. So, you don't necessarily need to be unfit for all work, just work similar to what you customarily did before you became disabled. This is an easier standard to meet than Social Security's standard, which requires that you can't do any type of substantial work.

On the other hand, Social requires your inability to work to last just one year, whereas the IRS requires you to be disabled for a "long and indefinite duration."

So, having been found disabled for Social Security disability or SSI purposes doesn't guarantee the IRS will allow you to use the disability exception to the 10% penalty, but it can help.

That said, if Social Security has classified your condition as "Medical Improvement Not Expected" (MINE), you'll likely meet the IRS's definition of totally and permanently disabled. 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.

Definition of Disability for Veterans Benefits

The IRS's definition of permanent and total disability is similar to the VA rating for a veteran who has been deemed 100% disabled "based upon individual unemployability" (TDIU). But having a 100% TDIU rating doesn't force the IRS to find you eligible for the exception to the early distribution tax.

Definition of Disability for Long-Term Disability

The definition of disabled found in most long-term disability (LTD) plans is similar to the IRS's defintion. Many LTD plans find you disabled if you can't do your own occupation, as does the IRS.

If your LTD insurance provider has found you unable to do "your own occupation" or "any occupation," you have a good chance of meeting the IRS's definition of disabled. But you'll still need a doctor's statement saying your disability is expected to be permanent or last a very long time.

How to Claim the Disability Exception to the Early Distribution Tax

Whether or not you've been found disabled by an agency other than the IRS, you'll still have to have evidence from your doctor of your disability, written before you take the distribution from your retirement plan. Specifically, you'll need a statement from your doctor that says you can't work due to a physical or mental disability and that you'll be unable to work permanently or for a very long time.

Filing Form 5329

Once you have the medical opinion, you'll need to file IRS Form 5329 when you submit your tax return for the year. Where the form asks for the code to the exception to the additional tax for early distributions, 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 there's a 03 in the box, your distribution was classified correctly. But if your 1099-R doesn't have a distribution code in box 7 or the code shown is incorrect—anything other than "03"—you'll need to complete Schedule 2 (Form 1040) and file it along with Form 5329 to claim the exception.

The exception is laid out in the Internal Revenue Code at 26 U.S.C. 72(t)(2)(A)(iii).

Getting Tax Help

You might benefit by consulting with a certified public accountant (CPA) or an enrolled agent (EA) before claiming an exception to the early distribution penalty on your tax return. You might also consider hiring a CPA or EA to do your tax return for the year(s) you take an early distribution.

Learn more about other types of assistance available for people with disabilities.