In order to qualify for exemptions from the 10% early distribution penalty tax, according to the Internal Revenue Service’s definition, you must demonstrate permanent incapacity or long-term inability.
AMBT-SNT trusts for disabled children may provide access to funds without incurring significant income tax burdens; however, that may not always be the case.
Taxes on IRA Distributions
Traditional IRA funds withdrawn before age 59 1/2 will typically incur income taxes and a 10-percent penalty tax, however the IRS allows an exception when money is distributed due to disability. To qualify, a physician must agree you suffer from mental or physical conditions that prevent engaging in “substantial gainful activity”, with long-term effects or permanent disabilities that will persist over an indefinite period of time.
To take advantage of the disability exception for their Simplified Employee Pension IRA or Savings Incentive Match Plan for Employers, an IRA owner should check box 3 (or 4 for SIMPLE IRAs) of his or her 1099-R (or box 4 if from a SIMPLE IRA) with code 3, which indicates their distribution was due to disability. Some financial organizations require fill-in-the-blank “Physician’s Statement”, though medical documentation from any source will suffice as supporting evidence for making such claims.
Early Withdrawal Penalty Tax
Withdrawals made prior to reaching age 59 1/2 will generally be included as income and subject to an additional 10% tax; one exception may apply in cases of disability.
To qualify for this exception, a doctor’s statement certifying your disability as lasting an extended period or permanently is necessary to make this exception valid. This stringent medical requirement mirrors those for Social Security disability benefits and must meet these exacting standards in order to qualify.
Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs and Insurance Contracts provides instructions for reporting disability distributions by listing code “3,” Disability in Box 7. Some financial organizations require documentation supporting your claim in order to qualify as an exception while other take a more hands-off approach by not reporting purported disability distributions; it will then fall on you alone when filing tax returns to report such matters with IRS directly.
Taxes on Distributions to Beneficiaries
When an IRA owner dies, their beneficiaries inherit it unless specifically provided otherwise in their will. Beneficiary designations on an IRA take precedence over wills for inheritance purposes; if an heir qualifies under IRS regulations as disabled they can avoid incurring the 10% penalty by providing evidence that their disability prevents substantial gainful activity and remains permanent.
If you withdraw an early distribution from either a traditional or Roth IRA, generally speaking you must pay a 10 percent penalty unless there are certain exceptions such as being disabled, purchasing your first home, or incurring high medical costs. When reporting such distributions on Form 1099-R forms they will typically use Code “3,” Disabled Distribution in Box 7.
Financial organizations do not appear to be required to evaluate whether an IRA owner’s disability meets IRS standards; many custodians have simply entered a “3” code into box 7 without further verification from them or documentation.
Taxes on Distributions to Trusts
Trustee of complex or qualified disability trusts are subject to tax on income they reinvest into the trust during any year; the first $13,450 of such income reinvestment will be subject to trust level taxation at 37% (2022 rates), rather than being taxed individually at their individual rates.
Form 1099-R provides instructions to enter distribution code 3, “Disability,” into Box 7 of your tax return. However, custodians generally do not assess whether or how disabled an individual is; ultimately it’s up to themselves or more often their physician to establish that they meet IRS definition of permanently and totally disabled status.
An official medical diagnosis that you are physically or mentally impaired and will prevent you from engaging in gainful activity for life should usually suffice as justification for the disability exception claim. This should not be confused with long-term disability (LTD) insurance’s determination that you cannot perform any occupation whatsoever.
