When a disability takes away your paycheck, retirement savings often become the only savings. If you are under 59 and a half, you have probably heard that early withdrawals cost an extra 10%. For people with a qualifying disability, that extra 10% may not apply at all.
The key word is qualifying. The tax code's disability test is stricter than most people expect, and it is not the same as the test your employer's disability policy uses. Here is how it works and how to prove it.
The exception in the statute
IRC Section 72(t)(1) adds a 10% additional tax to the taxable portion of early distributions from qualified retirement plans, which include IRAs and employer plans. Section 72(t)(2)(A)(iii) lists one of the exceptions: distributions "attributable to the employee's being disabled within the meaning of subsection (m)(7)."
Unlike the medical expense exception, which is capped by the amount of your medical bills, the disability exception is not tied to what you spend the money on. If you meet the test, distributions attributable to the disability are excepted from the 10% additional tax. They are still income. The exception removes the add-on, not the regular tax.
The definition: Section 72(m)(7)
Section 72(m)(7) says an individual is 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." It adds that the individual is not considered disabled "unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require."
Break that into its parts:
- Unable to engage in any substantial gainful activity. Not just unable to do the job you had last month.
- Because of a medically determinable impairment. Physical or mental, but it must be diagnosable.
- Expected to result in death or to be of long-continued and indefinite duration. Temporary conditions do not qualify.
- Proof. You have to be able to show it.
How the regulation fills in the details
Treasury Regulation Section 1.72-17A(f) explains how the IRS applies the definition. A few points matter most.
Your customary work is the benchmark
The regulation says that in deciding whether an impairment prevents substantial gainful activity, "primary consideration shall be given to the nature and severity of his impairment," and consideration is also given to education, training and work experience. It then says the substantial gainful activity it refers to is "the activity, or a comparable activity, in which the individual customarily engaged prior to the arising of the disability." That is more favorable than many people assume. The question is generally your customary work or comparable work, judged on all the facts.
The regulation gives examples
The regulation lists impairments that "would ordinarily be considered as preventing substantial gainful activity," including loss of use of two limbs; certain progressive diseases that have resulted in physical loss or atrophy of a limb; diseases of the heart, lungs or blood vessels with major loss of heart or lung reserve; cancer which is inoperable and progressive; brain damage with severe loss of judgment, intellect, orientation or memory; mental diseases requiring continued institutionalization or constant supervision; severe vision loss; permanent and total loss of speech; and total deafness uncorrectable by a hearing aid.
But it also warns that having one of those conditions "will not, however, in and of itself always permit a finding" of disability. Every impairment "must be evaluated in terms of whether it does in fact prevent the individual from engaging in his customary or any comparable substantial gainful activity."
Indefinite means indefinite
The regulation says "indefinite" means it "cannot reasonably be anticipated that the impairment will, in the foreseeable future, be so diminished as no longer to prevent substantial gainful activity." It gives a memorable example: someone with a bone fracture that keeps him out of work for an extended period is not disabled if recovery can be expected in the foreseeable future, but if the fracture persistently fails to knit, the individual would ordinarily be considered disabled. It also says that "ordinarily, a terminal illness because of disease or injury would result in disability."
How this differs from other disability tests
Your long-term disability insurer may pay benefits because you cannot perform your own occupation. Social Security has its own definition. A student loan holder has its own process. None of those determinations automatically decides the tax question, although strong medical evidence from any of them can support it. Treat each test separately, and build your tax file around the 72(m)(7) language.
If the impairment is terminal, there is also a separate terminal illness exception with its own certification rules. I cover it in retirement withdrawals for medical bills.
Proving it
IRS Publication 590-B describes the proof for IRAs in practical terms. You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition, and "a physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration."
Build a file that includes:
- A physician's statement describing the impairment, stating that it prevents you from engaging in your customary or comparable work, and stating that it is expected to result in death or to be of long-continued and indefinite duration.
- Supporting medical records for the diagnosis and its severity.
- Any disability determinations from Social Security or an insurer, as supporting evidence.
- A short description of the work you customarily did before the disability.
You generally do not send this with the return. Keep it. If the IRS questions the exception, this file is your answer.
Reporting the distribution
The payer reports the distribution on Form 1099-R. The instructions for Form 1099-R assign distribution code 3 to disability, referencing Section 72(m)(7). If your plan used code 3, the exception is reflected. If the form shows code 1, early distribution with no known exception, you claim the exception on Form 5329 using exception code 03, for total and permanent disability.
Plans often code distributions as code 1 because they do not have your medical information. That does not mean you lose the exception. It means you have to claim it.
Disability shows up elsewhere in the tax code too
- Health savings accounts. The 20% additional tax on non-medical HSA withdrawals does not apply after you become disabled within the meaning of 72(m)(7). See HSA withdrawals during a medical crisis.
- Estimated tax penalties. IRS Tax Topic 306 says the IRS may waive the underpayment penalty if you became disabled during the tax year or the preceding year and the underpayment was due to reasonable cause and not willful neglect.
- Employer plans after a layoff. If you left your job, the order in which you roll over and withdraw can matter for other exceptions. See cashing out a 401(k) after a layoff.
The bottom line
If a medically determinable impairment keeps you from your customary or comparable work and is expected to last indefinitely or result in death, retirement withdrawals attributable to that disability avoid the 10% additional tax. The withdrawals are still taxable income. Get the physician's statement before you need it, keep the file, and claim the exception on Form 5329 if the 1099-R does not.
The disability is hard enough. The 10% does not have to be part of it.
Frequently asked questions
What counts as disabled for the early withdrawal exception?
Under IRC 72(m)(7), you must be unable to engage in any substantial gainful activity because of a medically determinable physical or mental impairment expected to result in death or to be of long-continued and indefinite duration. Treas. Reg. 1.72-17A(f) measures this against your customary or comparable work.
Does the disability exception make the withdrawal tax free?
No. It removes the 10% additional tax under Section 72(t). The taxable portion of the distribution is still included in your income and taxed at your ordinary rates. Plan withholding or estimated payments accordingly.
How do I claim the disability exception if my 1099-R shows code 1?
File Form 5329 with your return and enter exception code 03 for total and permanent disability on the line for the amount not subject to the additional tax. Keep a physician's statement and supporting records in case the IRS asks for proof.
If Social Security approved my disability, do I automatically qualify?
Not automatically. Section 72(m)(7) is its own test, and the regulation says each impairment must be evaluated on whether it actually prevents your customary or comparable substantial gainful activity. A Social Security determination can be strong supporting evidence, though.
This guide is general information, not legal advice. Tax law changes and every case turns on its own facts.