Dear Tax Talk,
I’m a quadriplegic currently receiving SSDI and my question is twofold. I was officially declared disabled by the Social Security Administration on July 1, 2016, and since that time I’ve taken out $30,000 from my 401(k). My investment firm withheld the 10 percent penalty and I also withheld extra tax.

So my questions are:

  • Am I entitled to get that 10 percent penalty back?
  • Do these early withdrawals from my 401(k) impact my ability to receive Social Security disability?

More to the point, do these withdrawals count as earned income, which would impact my benefits?

Thank you for your time!
— Shaun

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Dear Shaun,
A 401(k) distribution is not considered earned income.

The general rule for distributions made from your 401(k) plan before you are 59 1/2 years old is that you must pay a 10 percent additional tax. However, due to your disability, you will meet one of the exceptions available and will not have to pay the additional tax.

9 ways to avoid paying early penalty when taking money out of 401(k):

  1. You have unreimbursed medical expenses that are more than 10 percent of your adjusted gross income (or more than 7.5 percent if you or your spouse was born before Jan. 2, 1952).
  2. The distributions are not more than the cost of your medical insurance due to a period of unemployment.
  3. You are totally and permanently disabled.
  4. You are the beneficiary of a deceased IRA owner.
  5. You are receiving distributions in the form of an annuity.
  6. The distributions are not more than your qualified higher education expenses.
  7. You used up to $10,000 in distributions to buy, build or rebuild a first home.
  8. The distribution is due to an IRS levy of the qualified plan.
  9. The distribution is a qualified reservist distribution.

You should be receiving a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., from your investment firm sometime in January. Along with the distribution amount and other information, you will see in box 4 the amount of federal income tax withheld. The income is reported on line 16 of your Form 1040 and the federal income tax withheld is reported on line 64.

The last step is to complete Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, and attach it to your return. You will complete Part I, Additional Tax on Early Distributions, and you will see that on line 2 is where you tell the IRS the exception that applies to you. For “disability,” the code is 03.

As far as Social Security reducing your benefits, it seems that they may be reduced if you get either workers’ compensation or other public disability benefit payments. I suggest that you confirm this with the Social Security Administration directly yourself.

Thanks for the great question, Shaun, and I wish you all the best in 2017.

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