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Disability Tax Code Benefits For Retirement Accounts

For many, disability is an unfortunate part of everyday life. Whether it be from injury, illness or otherwise, being disabled can be physically trying and mentally challenging. It can also be tough on your wallet, as being disabled often carries with it additional medical costs, not to mention a possible loss of earning power. Certainly no one in their right mind would ever choose to be disabled, but if life has dealt you this hand, there are a few benefits available under the tax code to help you make the most of your retirement accounts.

Below are three such benefits, discussed in greater detail. One important point to remember here though is that for each of these tax benefits, you have to be disabled as defined by 72(m)(7) of the tax code, which is a very restrictive definition. Essentially, this provision says that you are so disabled you cannot work at all and that your disability is expected to either result in death or be of an indefinite duration. It’s that strict.

10% Penalty Exception
In general, distributions from IRAs and other retirement accounts are subject to a 10% penalty if distributions are taken prior to the time you turn age 59 ½. There are a number of exceptions that can get you out of this penalty though. One such exception is the exception for disability. If you are disabled, as defined by the tax code, you can take penalty-free distributions at any age. However, regular income tax is still due on the early distributions. Your custodian will probably code your distributions with a “no known exception” even though you are disabled, so to get out of the penalty you will have to file Form 5329 and provide an explanation of your disability. It’s a good idea to have supporting documentation from one or more physicians as well.

Stop Your 72(t) Distributions
Another exception to the 10% penalty for early distributions is for a series of substantially equal periodic payments, more commonly known as 72(t) payments. While these types of payments can help you avoid the 10% penalty for a portion of your retirement savings, they come along with a very rigid schedule and set of rules. For instance, distributions must continue for the longer of five years or until age 59 ½. You also can’t add or subtract, roll into or roll out of an account from which these distributions are being taken. If these rules are broken in any way, the 10% penalty is retroactively applied to all pre-59 ½ distributions, along with interest. There are only two ways to break the schedule without incurring these penalties, and neither is good. Death is one way, and disability is the other.

Make an NUA transaction
For some, one of the biggest tax breaks in the entire tax code is the tax break for net unrealized appreciation, or NUA. In essence, this lump-sum distribution tax planning strategy allows you to trade ordinary income tax rates for long-term capital gains rates for a portion of your retirement savings. This particular tax break can only be used when you have appreciated securities (usually stock or a stock fund) of the company you work for inside your qualified plan, like a 401(k). There are a lot of rules to contend with in order to successfully use this strategy, but one of those rules is that an NUA transaction can only be made after a triggering event. Disability is one of those triggering events, but only if you are self-employed. If you’re not self employed, disability doesn’t help you here.

Disability can not only be hard on the mind and body, but also on the wallet. If you or someone you love is unfortunately in the predicament, every dollar may count. Using one or more of the three tax benefits above can help you keep Uncle Sam at bay so you get to keep more of your hard-earned money.

Article Highlights:

If you are disabled, you can receive these three benefits under the tax code:

  • The 10% penalty exception: You can take penalty-free IRA distributions at any time
  • Stop 72(t) distributions: You can break the schedule of 72(t) distributions
  • Make an NUA transaction: This transaction can only be made after a triggering event. Disability is one of those events.
 - By Jeff Levine and Jared Trexler


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Consumers: Send in Your Questions to [email protected]

Can I transfer money from my IRA to my husband's Roth IRA? I am 35, and he is 36.

Thank you!

Gail Clements

No. The only way your IRA funds can be transferred to your husband’s IRA is in a divorce or after your death. Even then, it would have to be transferred to a similar IRA, for example an IRA to IRA or a Roth IRA to another Roth IRA. In this case, you cannot transfer your IRA into your husband’s Roth IRA.