Are IRA Distributions Taxable If You Are Disabled?
An Individual Retirement Accounts’ primary goal is to promote saving for retirement, so the IRS has instituted an early withdrawal penalty tax when an IRA account is emptied prematurely.
One exception to this penalty exists for disabled individuals; to qualify, they require a doctor’s statement verifying their incapacity for any substantial gainful activities.
Taxation of IRA Distributions Due to Disability
Although some disabilities may qualify for an exception to the 10% early withdrawal penalty tax, the IRS defines disability strictly. They require proof that a physical or mental condition prevents someone from engaging in “substantially gainful activity”, and is expected to last an extended period; not just temporary illnesses.
Due to the narrow definition of disability, financial organizations often opt not to report disability as part of IRA distributions on Form 1099-R when reporting them. Instead, they use code 1, “Early Distribution No Known Exception,” leaving IRA owners the responsibility of filing IRS Form 5329 with any valid claims for exceptions they make claiming disability on. This approach also enables organizations to acquire documentation supporting claims of disability from IRA owners; however, any earnings portion must still pay income taxes regardless of any claims for exception.
SEP IRAs and SIMPLE IRAs
SEP and SIMPLE IRAs are retirement savings vehicles designed specifically to meet the needs of small business owners, including self-employed individuals, that allow higher maximum contributions than traditional or Roth IRAs, while also permitting their employers to match these contributions, similar to 401(k).
SEP and SIMPLE IRAs adhere to traditional IRA rules, so any distributions from either account to an individual who is disabled are fully taxable. Furthermore, to claim an exception from the 10-percent penalty tax for qualified plans (including IRAs ) and other tax-favored accounts on his or her tax return, an owner of such an account should file Form 5329 Additional Taxes on Qualified Plans (Including IRAs ) and Other Tax-Favored Accounts with his or her tax return.
Plan benefits of Individual Retirement Accounts (IRAs) include immediate vesting – meaning the money becomes yours as soon as it’s deposited – and investing with either pre-tax (through traditional IRA) or post-tax dollars (Roth IRA). Plus contributions can be made throughout the year unlike 401(k).
Traditional IRAs
As a general rule, anyone can open and make contributions to traditional individual retirement arrangements (IRAs). However, your annual earnings determine how much money can be contributed.
If you withdraw funds from an IRA before age 59 1/2, income tax and a 10 percent penalty apply. There may be exceptions if you’re disabled, using it for home purchases, or incurring high medical costs.
To qualify for the disability exception, you’ll need a doctor’s opinion stating that you suffer from either physical or mental impairment that prevents you from engaging in substantial gainful activity for an indefinite period of time. Additionally, IRS Form 5329: Additional Taxes on Qualified Plans and IRAs must also be filed along with your return in order to claim this exception; many financial organizations choose not to report distributions from traditional IRAs using code 3 (disability); instead they ask owners themselves to file claims under this exception on their returns in order to claim this benefit.
Long-Term Disability Insurance
Long-term disability (LTD) insurance provides income replacement in the event of illness or injury that prevents you from working, though its definition differs from that used by the IRS and therefore a doctor’s statement may be necessary to satisfy them that your impairment meets its standards.
Social Security Disability Insurance (SSDI) and Supplemental Security Income (SSI) are two programs administered by the Social Security Administration (SSA). According to their definition of disability, both programs will cover conditions which prevent you from engaging in substantial gainful activity for a minimum period of time (usually one year or longer) that prevent participation.
Before applying for SSDI or SSI benefits, recipients must spend down their non-countable assets such as IRAs. Furthermore, proof that you qualify for disability exemption from age 59 1/2 penalty tax may require a doctor’s letter; some financial organizations now forbid using code 3 on Form 1099-R when reporting distributions under this exception and instead ask owners of IRAs to provide supporting documentation of how their claim meets disability exception rules.
Categorised in: Blog