ComplianceMarch 26, 2019

Disability and IRA distributions



Overview

In addition to regular income tax, distributions taken by an IRA owner prior to age 59½ are subject to an additional tax of 10 percent, unless an exception applies. The 10 percent penalty tax is waived for an IRA owner who meets the definition of disability as it relates to an IRA. This article will define disability for IRA purposes, and explain how an IRA custodian or trustee reports disability distributions to IRA owners and the Internal Revenue Service (IRS).

Disability defined

For IRA purposes, the definition of disability is found in Internal Revenue Code (IRC) Section 72(m)(7). It states that “…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.” Not exactly an easy to understand definition. For example, if an IRA owner has physical limitations, but earns a salary on a regular basis as a programmer, he/she is substantially gainfully employed. However, due to physical limitations, if he/she is able to only work as a volunteer two days out of the month, the IRS might not consider the work substantial or gainful.

The statute further states that “an individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the secretary [Secretary of the Treasury] may require.” This proof could be in the form of a physician’s statement identifying the disability as meeting the above requirements.

Income Tax Regulation Section 1.72-17A(f)(1) further states that the substantial gainful activity “…is the activity or a comparable activity in which the individual customarily engaged prior to the arising of the disability….” It also states that “…primary consideration shall be given to the nature and severity of his impairment. Consideration shall also be given to other factors such as the individual’s education, training, and work experience.”

The regulation does provide a list of impairments which would ordinarily satisfy the definition. Some examples from the list are:

  1. Loss of use of two limbs;
  2. Diseases of the heart, lungs, or blood vessels which have resulted in major loss of heart or lung reserve so that, despite treatment, pain or fatigue is produced on slight exertion;
  3. Inoperable cancer which is progressive;
  4. Certain brain damage and other mental diseases;
  5. Permanent and total loss of speech; or
  6. Total deafness uncorrectable by a hearing aid

This is just a partial list from the regulations, but it identifies the types of impairments that might meet the disability definition.

Duration of the disability

Another factor to be considered in determining disability is its duration. The disability must result in death or “… continue for a long and indefinite period…” If the impairment has all the other attributes of disability, there must also be no foreseeable remedy. In other words, no statutory disability exists where a “disability” today will be remedied in the near future. This would include inoperable conditions and other diseases which progressively deteriorate the body and will presumably result in death.

The regulation contains an example of an individual who suffers a bone fracture which prevents him from working for an extended period of time, and will not be considered disabled if his/her recovery can be expected in the foreseeable future; if the fracture persistently fails to heal, that individual would ordinarily be considered disabled.

As you can see, although the regulation provides guidance in defining disability, the regulation makes no assurances as to what is or is not a disability that satisfies the definition in the statute. Instead it states that all the facts in the case are to be considered and evaluated to see if the impairment does “…in fact prevent the individual from engaging in his customary or any comparable substantial gainful activity.”

Reporting disability IRA distribution

Distributions are reported on IRS Form 1099-R Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. using a specific IRS code in box 7 which identifies the distribution reason. A disability distribution paid to a Roth IRA owner is quite simple, as you will see in the chart below. However, distributions taken from a traditional IRA prior to age 59½ due to disability, may require a discussion regarding the financial organization’s policy.

The chart below identifies the IRS distribution reporting codes that are used to report disability distributions taken from a traditional or Roth IRA.

Table title

IRA Type IRS Code Reason
Traditional Code 1, Early Distribution, No Known Exception IRA owner is younger than age 59½ and does not provide proof of disability, or financial organization policy*
Traditional Code 3, Disability  IRA owner is younger than age 59½ and certifies his/her disability by signing a distribution form, and/or provides proof of disability

 Roth

Code J   IRA owner is younger than age 59½ and does not provide proof of disability, or financial organization policy*
 Roth Code T IRA owner certifies his/her disability by signing a distribution form, and/or provides proof of disability, however has not met the five-year holding period
 Roth Code Q IRA owner certifies his/her disability by signing a distribution form, and/or provides proof of disability and has met the five-year holding period

*A distribution reported as an early distribution may require an IRA owner to file IRS Form 5329 Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts to claim exemption from the 10 percent penalty tax for the disability.

Conclusion

The definition of disability is not “clear cut”. An IRA owner who takes distributions due to disability may be required to provide a physician’s statement to his/her IRA custodian/trustee for disability reporting purposes. Ultimately, if an IRA owner is audited it is his/her responsibility to prove his/her disability to the IRS. An IRA custodian/trustee is responsible for proper IRS reporting. For traditional IRAs this means creating a policy to determine how to report disability distributions.

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Diana Theis
Senior Specialized Consultant, Tax Advantaged Accounts
With more than 30 years of experience, Diana has worked closely with hundreds of financial organizations to help them create, implement, and maintain their tax-advantaged accounts program.
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