What is the Definition of Disability for Purposes of the Early Distribution Penalty Tax?

The ERISA consultants at the Learning Center Resource Desk, which is available through Columbia Threadneedle Investments, regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Maryland is representative of a common inquiry regarding penalty exceptions for early distributions from retirement accounts. The advisor asked:

“How does the IRS define disability for the purposes of allowing a 401(k) plan participant to take a distribution before the age of 59½ without a penalty tax?”

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 publication, Retirement Topics – Exceptions to Tax on Early Distributions, for other penalty exceptions.

Conclusion

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.

The Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC (RLC), a third-party industry consultant that is not affiliated with Columbia Threadneedle. Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle does not provide tax or legal advice. Consumers consult with their tax advisor or attorney regarding their specific situation.

Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Columbia Threadneedle.

Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies.

©2017, Columbia Management Investment Advisers, LLC. Used with permission.

Add Your Comments

2 Comments

  1. Michael Driscoll
    Posted April 12, 2017 at 11:18 am | Permalink

    John – your column raises a question perhaps you can address. It has come to my attention that effective 1/18/2018 all (ERISA) retirement plans will be required to use, for qualifying/authorizing plan withdrawals due to disability, either a Social Security Administration benefit award or the benefit award of the Long-Term Disability insurer/provider utilized by the employer – and that a physicians opinion will no longer be an acceptable form of documentation of disability. This suggests it will no longer be acceptable to use a plan’s current process of using/requiring a physician to declare the permanent disability status.

    I am concerned plan sponsors will be out of compliance in less than a year if they use a physicians determination alone. The new regulation was apparently signed into the Federal Register on January 18, 2017 with an applicability date of January 18, 2018. Do you agree this change will impact the process you described in your column? The regulation can be found in the Federal Register at 29 CFR Part 2560, or EBSA 2015 – 0017, or Docket Number 1210-AB39.

    Thanks.

    Michael Driscoll

  2. Posted April 15, 2017 at 2:41 pm | Permalink

    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.” It is important that plan administrators review their disability claims procedures, including acceptable forms of documentation.

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