Are IRA Distributions Taxable If You Are Disabled?
IRAs are an efficient way for many to save for retirement while taking advantage of tax breaks, but for people receiving disability benefits the process may become more challenging.
Disability benefits could be affected by withdrawing from an IRA; however, there are certain exceptions to the 10% early withdrawal penalty that allow early access.
What is the definition of disability?
As part of its IRA withdrawal rules, the IRS defines disability as any medical condition which limits your ability to engage in gainful activity and which can last at least one year and may even be chronic.
Sometimes a condition can also qualify as a disability under Social Security rules; however, their definition of disability differs considerably from that of the IRS.
IRA owners claiming the disability exception must provide evidence that they meet the IRS’s “total and permanent” definition of disability. Some financial organizations may request that a physician complete and sign off on a Physician’s Statement found within Instructions for Schedule R (IRS Form 1040) Credit for Elderly or Disabled; however, others simply ask owners to file an extra tax form in their return in order to claim this exception; likely as they do not want the responsibility of collecting and assessing disability documentation themselves.
What is the penalty for early withdrawals?
Individuals withdrawing funds from an IRA before age 59 1/2 must generally pay a 10% penalty, however there is an exception available from the IRS in cases of disability-related distributions.
To qualify, an individual must suffer from a medical condition which prevents them from working and that cannot be remedied with medications or treatments.
When disabled persons make withdrawals from their retirement accounts, financial organizations typically report it to IRS on Form 1099-R with code 3 for disability as their reporting code. But financial organizations must exercise caution in this process as instructions only briefly mention claiming disability exemption but don’t specify which documents must accompany such claims.
Penalties do not apply to certain home purchases and educational expenses that must be used within 120 days, with a $10,000 lifetime cap in effect.
What is the exception to the penalty for disability?
As a general rule, withdrawals made from an IRA before age 59 1/2 are considered “early distributions” and subject to an additional 10 percent penalty tax unless one of the exceptions exists, such as disability exception.
The disability exception allows you to access your IRA without incurring the 10% penalty if you can demonstrate that you are permanently and totally disabled, meaning you are incapable of engaging in any gainful activity due to physical or mental impairment which will continue for an indefinite period or will lead to your death.
To be eligible for this exception, a more stringent definition of disability than that used by Social Security Administration and most LTD plans must be met. A medical opinion from a licensed doctor must accompany your tax return detailing how and when you took out distributions.
What is the exception to the penalty for early withdrawals?
When withdrawing money from an IRA prior to reaching age 59 1/2 for disability and can demonstrate its permanent nature, no penalties apply. You must demonstrate that physical or mental conditions prevent substantial gainful activity over your lifetime and might lead to death.
IRS Instructions for Form 1099-R list “3,” Disability, as a distribution code in Box 7, and require that IRA owners file an additional tax form to claim this exception. However, certain financial organizations have refused to use this code, instead reporting all distributions as “1,” Early Distribution Without Any Known Exception,” leaving IRA owners to submit documentation and file the appropriate tax form with the IRS themselves.
Withdrawals from an IRA may be exempt from penalties when used to cover medical expenses not reimbursed by insurance, to purchase your first home and satisfy an IRS levy. You can also avoid this penalty if withdrawing to pay federal income taxes or assist your child with tuition costs associated with an eligible education expense.