Are IRA Distributions Taxable If You Are Disabled?
Unless one of the exceptions (such as disability) applies, withdrawing funds before age 59 1/2 typically attracts an early withdrawal penalty of 10%. Disability may be one of these exceptions.
Prior to Secure, trustees could use excess IRA distributions that exceed disabled beneficiaries’ needs as “holding funds”, taxed inside a trust for future use. Unfortunately, this came at a steep cost.
What is the definition of disability?
Many individuals with disabilities rely on government assistance through programs like Social Security Disability Insurance and Supplemental Security Income; their benefits could be affected by how IRA withdrawals are reported and handled with regards to early distribution penalties (usually 10%).
To qualify for an exemption from the 10% penalty due to disability, either by being found disabled by an agency other than the IRS or satisfying the legal definition: an impairment that prevents someone from performing substantial gainful activity and may last long term or be permanent. Form 1099-R lists code 3 for disabled as an option when reporting distributions as disability distributions; however, documentation may still need to be provided in order for eligibility.
The 10% early distribution penalty may also be waived for beneficiaries who are disabled or chronically ill, accumulation see-through trusts in which designated beneficiaries use their own life expectancies to calculate required minimum distributions (using the Single Life Table), accumulation see-through trusts where designated beneficiaries use life expectancies to determine required minimum distributions (using Single Life Table), as well as accumulation trusts that use life expectancies instead of age as the basis for required minimum distributions (using Single Life Table). However, this ‘special rule’ does not apply for shares created in an IRA specifically for surviving spouse beneficiaries, minor children, designated beneficiaries less than 10 years younger than the IRA owner.
What is the definition of permanent and total disability?
A disabled IRA owner looking to take advantage of the exception from early distribution penalties must provide proof that she meets IRS definition of permanent and total disability. Financial organizations increasingly aren’t using code 3 on 1099-R (indicating known disability exception) but instead asking IRA holders themselves to supply documentation of disability.
This approach could prove advantageous to certain families as it allows annual IRA distributions to more closely align with supplemental needs of disabled beneficiaries, as well as avoid having to file Form 5329 to claim exception to early withdrawal penalty should IRS question the evidence provided in support of early withdrawal penalty exemption. No matter which approach is taken, its success hinges on providing adequate documentation.
What is the definition of disability for IRA distributions?
Contrary to what the Social Security Administration requires, the Internal Revenue Service definition of disability doesn’t require you to demonstrate it is both permanent and total; rather it simply needs to last indefinitely and prevent you from working at substantially gainful capacity.
As a disabled beneficiary, having verification from your doctor that you meet the statutory definition of disability can help avoid paying the 10% early distribution penalty from an IRA. Unfortunately, financial organizations do not wish to become involved in determining how disabled you are; as a result they’ll probably report your distribution with code “1,” signifying it is an early distribution with no known exception on Form 1099-R.
Financial organizations are becoming more willing to skip using that code altogether and allow you to claim disability exception on your tax return instead. You would still need to submit Form 5329 but providing evidence from a doctor should suffice as evidence to show IRS that you meet its definition of disability.
What is the definition of disability for SSI distributions?
SSI disability program definition of disability differs from that used by the IRS; its rules require you to demonstrate that your inability to work is due to an ongoing, severe medically determinable physical or mental impairment expected to last a significant period of time or lead to death.
Form 1099-R’s instructions provide code “3,” Disability, as a distribution code to be entered in Box 7. However, financial organizations have the flexibility to report such distributions either using code 3 with supporting documentation from their IRA owners or by reporting early distributions made under disability exception with code 1, Early Distribution No Known Exception instead.
This distinction may seem subtle, but it’s crucial in understanding why the definition of disability for Social Security Disability Insurance (SSI) and exception from its 10% early withdrawal penalty is so stringent. That is to say, it can be very hard to bypass this rule even though many LTD insurance providers find you permanently and totally disabled due to individual unemployability (TDIU). Therefore, independent physician evaluations should always be sought as they provide invaluable insight.
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