If you take an early distribution from an individual retirement account (IRA), 401(k), 403(b), or other qualified retirement plan (possibly including Roth IRA's) before reaching age 59 1/2, the government will require you to pay an additional tax. The reason for this is that the government is trying to encourage people to save for retirement. A lot of people who get disability benefits have to tap into their 401k plans to pay bills and take care of other expenses. When you do that, you usually will get a Form 1099-R for the distribution, and box 7 will usually be checked indicating it is a loan. Other codes may appear on the 1099, and that will be explained below. Typically, you have to pay the loan back at a reasonable interest rate, or you face paying a 10% early withdrawal penalty.
Does a disabled person have to pay the early withdrawal penalty?
No, if you are disabled, you can avoid paying the 10% penalty. Disability is one of several exceptions to the requirement that you have to pay the early withdrawal penalty.
How do I know if the 401k plan administrator classified my withdrawal as a disability?
If your 401k plan administrator sent you a 1099-R with a code 03 on it, you should not need to do anything. Code 03 is the code for disability withdrawal. However, most distributions are not coded as a 03. Here is a list of IRS codes that you might see in your 1099:
Distribution Code -- Meaning
1 Early distribution, no known exception
2 Early distribution, exception applies
5 Prohibited transaction
6 Section 1035 exchange
7 Normal distribution
8 Excess contribution
9 Cost of life insurance protection
A May be eligible for 10-year tax option
D Excess contribution
E Excess annual additions
F Charitable gift annuity
G Direct rollover
J Early distribution from Roth IRA
L Loans treated as deemed distributions
N Recharacterized IRA contribution
P Excess contribution
Q Qualified distribution from Roth IRA
S Early distribution from a SIMPLE IRA - first 2 years, no known exception
T Roth IRA distribution
How do I correct the wrong code and reclassify my early withdrawal under the disability exception?
I strongly recommend that you hire a Certified Public Accountant to help you with your tax return when you are trying to avoid paying the 10% early withdrawal penalty. You will want to speak with your CPA about filing IRS Form 5329 and entering code 03 on the form in the appropriate box.
What proof do I need to show that I am disabled?
The general rule is that you have to prove you have a permanent and total disability. That is one or more physical or mental conditions that keep you performing substantial gainful activity (i.e. work). If you get Social Security Disability, this is essentially what you proved to Social Security to get approved for disability. It is also the similar language to what the government uses in Veterans Disability cases for a person to prove 100% disability based upon individual unemployability (often called a claim for 'TDIU'). If you get Long Term Disability benefits under an insurance policy or ERISA (employer group) plan, it would be similar to proving that you cannot do "any occupation." In the end you will need one or more doctors to certify that you have a permanent and total disability, but showing that get these other benefits will help you prove that you are disabled as well.
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