If you find yourself without a job or facing unemployment, one of the options you might consider is taking a distribution from your retirement account. This is especially true if you are disabled and need the income to pay for your living costs or even your medical care.
These distributions often result in additional Federal income taxes being owed and can even trigger the 10 percent additional tax if you are under 59 1/2 years old at the time of the distribution. There are several exceptions that may apply to the additional tax on early distributions, such as the exception for being “disabled.” If any of these exceptions apply, you can escape liability for the 10 percent additional tax.
The definition of “disabled” for tax purposes is different from the common understanding of the term. A recent court case, Lucas v. Commissioner, T.C. Memo. 2023-9, provides insight into how this definition is applied in the context of a taxpayer who has diabetes.
Facts & Procedural History
This case involves a taxpayer who took an early retirement distribution in 2017 when he lost his job. The taxpayer was a software developer and was suffering from diabetes.
The taxpayer reported the $19,365 401(k) plan distribution on his 2017 tax return, but he did not include it as taxable income and did not compute the 10 percent early distribution tax. He took this position based on the argument that his medical condition as a diabetic means that he is disabled.
The IRS’s computer matching system no doubt caught this issue, as the retirement plan had issued a Form 1099 to the taxpayer and the IRS. It is also probable that the taxpayer went through a correspondence audit with the IRS, resulting in the additional income tax and addition to tax under Sec. 72 that is the issue of this case in the U.S. Tax Court.
Taxes on Retirement Account Distributions
The laws for income taxes generally require that 401(k) plan distributions be reported as income and be subject to taxes.
We typically see this with distributions from Individual Retirement Accounts (IRAs) which are reported on Line 4a and 4b of Form 1040, the individual income tax return form. The 4a box is for the full distribution amount and the 4b box is for the taxable portion of the distribution. It is common for taxpayers to fill in the 4a box and omit the information in 4b. However, for most taxpayers, the correct way to report the distributions on the income tax returns is to have the taxable amount in box 4b and leave box 4a blank. This often leads to an understated tax that is caught by the IRS’s computer systems, as omitting information in 4b results in the distribution not being subject to income taxes.
The Sec. 72 Addition to Tax
In addition to the income tax that is generally required for 401(k) plan distributions, there is an additional tax of 10 percent that is imposed by Section 72 if the recipient is under 59 1/2 years old at the time of the distribution. This additional tax, commonly known as the “early distribution penalty tax,” is an additional tax imposed on distributions that are received before the individual reaches the age of 59 1/2. The purpose of this tax is to discourage individuals from accessing their retirement savings before they reach retirement age, as these funds are intended to be used for retirement.
The additional tax of 10 percent is reported to the IRS on Form 5329, the Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. This form is used to report the additional taxes imposed on early distributions from qualified plans, including 401(k) plans, as well as other tax-favored accounts such as IRAs. Taxpayers must report the early distribution penalty tax on Form 5329, and then add the amount of the penalty tax to the taxes owed on Form 1040, the individual income tax return form.
The Exceptions for the Addition to Tax
There are several exceptions to the additional tax of 10 percent imposed by Sec. 72 on early distributions from qualified retirement plans, including 401(k) plans, for individuals who are under 59 1/2 years old at the time of the distribution. Here are the most common exceptions:
- The distribution is made to a beneficiary (or to the estate of the employee) after the employee’s death.
- The distribution is made because the employee is disabled.
- The distribution is made as part of a series of substantially equal periodic payments over the life expectancy of the employee or the joint life expectancy of the employee and the employee’s beneficiary.
- The distribution is made to an alternate payee under a qualified domestic relations order, which is a divorce tax planning strategy.
- The distribution is used to pay certain qualified higher education expenses.
- The distribution is used to pay certain qualified first-time homebuyer expenses.
- The distribution is made to a reservist called to active duty after September 11, 2001.
- The distribution is made to a taxpayer who is unemployed and uses the distribution to pay for health insurance.
- The distribution is made to a taxpayer who is experiencing financial hardship.
There are regulations and numerous court cases that help clarify these exceptions.
What Does “Disabled” Mean?
This case focuses on the second exception, i.e., that the taxpayer is “disabled.”
Sec. 72 defines the term “disabled” as follows:
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. 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 may require.
In order to qualify for this exception, the individual must furnish proof of the existence of their disability in the form and manner required by the Secretary of the Treasury. This is typically done by submitting a statement from a qualified medical professional.
The taxpayer had been diagnosed with diabetes, and he argued that his medical condition should qualify him for the disability exception. Thus, the court had to decide whether the taxpayer’s diabetes meant that he was “disabled” and not subject to the 10 percent additional tax on early distributions.
Does Diabetes Rise to the Level of a Disability?
The court noted that the phrase “substantial gainful activity” is defined in the regulations and refers to “the activity, or a comparable activity, in which the individual customarily engaged prior to the arising of the disability.”
The court also stated that the determination of whether an impairment makes one unable to engage in substantial gainful activity depends on all the facts of the case, focusing primarily on the nature and severity of his impairment, as well as factors such as the individual’s education, training, and work experience. The rule focuses on being able to work. It includes a rule that says that an individual will not be deemed disabled if, with reasonable effort and safety to himself, the impairment can be diminished to the extent that the individual will not be prevented by the impairment from engaging in his customary or any comparable substantial gainful activity.
This “gainful activity” analysis departs from evaluating factors, such as the individual’s blood sugar levels, overall health, and ability to perform daily tasks and whether the individual has any other related conditions or complications as a result of their diabetes, as well as the treatment they are receiving for their condition. These factors do not need to be considered, per se.
It should also be noted that the guidance and criteria set by the Social Security Administration (SSA) for determining when an individual’s diabetes is considered a “disability” do not apply. The SSA has a specific listing of medical conditions, which includes diabetes, which, if met the criteria, is considered a “disability” for purposes of Social Security Benefits.
Given the facts and evidence in this case, the court concluded that diabetes is not a disability. This was largely due to the taxpayer’s occupation of being a software engineer, which does not require significant physical abilities. The court might have reached a different conclusion if the taxpayer had a more labor-intensive occupation.
This standard also does not foreclose on other ailments from qualifying, such as depression and anxiety.
As can be seen from this court case, the evidence presented during the trial is critical in these cases. The absence of evidence results in the tax being assessed, in addition to the 10 percent additional tax.
Individuals who are considered disabled usually have to report distributions from their retirement accounts as income, but they may be eligible for an exception to the additional tax of 10 percent imposed on early distributions if they are under 59 1/2 at the time of the distribution. The rules for determining whether an individual is considered disabled for the purpose of this exception primarily focus on the individual’s ability to engage in substantial gainful activity in their occupation, rather than the specific impact of their medical condition on their overall health. As such, those with less physically demanding occupations may find it challenging to qualify for this exception. If a taxpayer does not qualify for this exception, they may still qualify for the “financial hardship” exception, which is a separate exception that might help in these types of cases. If this fails, the taxpayer may still be able to settle the tax liability for less than the amount owed.