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Early retirement distributions for disabled


Dear Tax Talk,
If a person with a disability such as ALS -- that will most likely cause an early death -- withdraws retirement funds early, is there a way around the 10-percent penalty? Can it be waived or lowered? Thank you. -- Robin

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Dear Robin,
In tax law, death and disability forgive a lot of unfavorable tax consequences.

A 10-percent penalty is generally imposed on the early withdrawal of retirement funds. Early withdrawal is defined as withdrawals made before age 59½. Several exceptions exist to the imposition of the penalty, including withdrawals due to disability. You are considered disabled if you cannot do any substantial gainful activity because of your physical or mental condition. A physician must be able to determine that your condition can be expected to result in death or to be of long, continued and indefinite duration.

The custodian of the retirement funds will report the distribution to the Internal Revenue Service. In certain cases they may want to withhold tax unless you make them aware that the distribution is on account of disability. The custodian will report the distribution on Form 1099-R and should furnish you a copy. Box 7 of the form relates to distribution codes. Code 3 indicates to the IRS that the distribution is due to disability and relieves you of the need to file Form 5329, relating to the 10-percent penalty, with your return. If the custodian reports the distribution as other than code 3, then you should file Form 5329 to prevent any misunderstanding with the IRS.

Although you're not subject to the early-withdrawal penalty, the distribution is taxable income. The amount of the distribution would be reported on either line 15 (for IRAs) or 16 (for pensions) of your Form 1040. Although the amount is income, you may be able to reduce your tax bill by carefully reviewing your expenses, especially as they pertain to medical deductions, which are described fully in IRS Publication 502, Medical and Dental Expenses.

-- Posted: Oct. 2, 2003




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