What is the definition of disability for purposes of the early distribution penalty tax?
“How does the IRS define disability for the purposes of allowing a 401(k) plan participant to take a distribution before the age of 59 ½ without a penalty tax?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
Highlights of Discussion
- Generally, amounts an individual withdraws from an IRA or retirement plan before reaching age 59½ are called ”early” or ”premature” distributions. Beyond including the pretax portion of an early distribution in taxable income for the year taken, the recipient must pay an additional 10% early withdrawal penalty tax, unless an exception applies [Internal Revenue Code Section (IRC §) 72(t)].
- There are several exceptions to the early withdrawal penalty tax found in IRC §72(t)(2)(A)-(G), including an exception for disability (IRC §72(t)(2)(A)(iii).
- The IRS defines disability for this purpose in IRC §72(m)(7), and the definition is quite strict:
“… an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof …”
- Some disabled individuals file IRS Schedule R, Credit for the Elderly or Disabled, with their IRS Form 1040s. The schedule requires a physician’s certification that a person meets the IRC §72(m)(7) definition of disabled. Alternatively, a physician’s signed statement attesting to an individual’s permanent and total disability can serve as proof of the condition.
- See the IRS’ Retirement Topics – Exceptions to Tax on Early Distributions for other penalty exceptions.
- It is important that plan administrators review their disability claims procedures, including acceptable forms of documentation. While the final disability claims regulations and accompanying FAQs (in particular Q&A 9) reference the Social Security Administration or the employer’s long-term disability plan benefit awards as two examples of disability documentation, the rules for pension plans do not seem to preclude other forms, as long as the disability finding is made by a party other than the plan for purposes other than making a benefit determination under the plan. Here is the wording from Q&A 9 of the DOL’s FAQs
“However, if a plan provides a benefit the availability of which is conditioned on a finding of disability, and that finding is made by a party other than the plan for purposes other than making a benefit determination under the plan, then the special rules for disability claims need not be applied to a claim for such benefits.”
While disability can qualify a distribution recipient for an exception to the early withdrawal penalty tax, the definition of disability for this purpose is rigorous and requires proof.