How to Report IRA Disability Distributions
By Agatha Schmidt, CISP, SDIP, CHSP
Early IRA distributions—or distributions taken before age 59½—are generally subject to a 10 percent early distribution penalty tax. But there are several exceptions to this age 59½ rule, including an IRA owner’s qualifying disability. The additional penalty tax will not apply to distributions that are properly taken under the disability exception.
The Internal Revenue Code (IRC) defines “disability” narrowly. The disability must meet the definition in IRC Section 72(m)(7): “. . . 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.” In other words, according to IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), the disability must be “total and permanent.” This is a high standard.
The Instructions for Forms 1099-R and 5498, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., list code “3,” Disability, as a distribution code for Box 7 of Form 1099-R. But the instructions give little guidance beyond this. So financial organizations must decide which of two approaches to use: 1) report disability distributions with code “3” and obtain appropriate supporting documentation from the IRA owner, or 2) use code “1,” Early distribution, no known exception, to report purported disability distributions, shifting the burden of claiming the disability exception on IRS Form 5329 to the IRA owner.
Using Code “3” to Report Disability Distributions
This reporting method has been quite common, and it remains a viable option. When using this approach, the financial organization should obtain suitable documentation supporting the disability claim. Of course, the next reasonable question may be what documentation should we require? Various documents could be sufficient. But the primary consideration is this: does the documentation adequately confirm that the IRA owner’s disability meets the statutory definition cited above?
Some financial organizations request that IRA owners submit the fill-in-the-blank “Physician’s Statement” that is found in the Instructions for Schedule R (IRS Form 1040), Credit for the Elderly or the Disabled. The Physician’s Statement contains language addressing the “total and permanent” disability requirement. So getting a medical provider to complete this form and submit it to the financial organization should satisfy the IRS that the code “3” was used properly to report the disability distribution. Other forms of documentation could also be used. And ultimately, it is up to the IRA owner to address any IRS concerns about whether the disability meets the definition.
Using Code “1” to Report Disability Distributions
Increasingly, financial organizations are refusing to use (disability) code “3” altogether for Form 1099-R reporting purposes. These financial organizations prefer to let IRA owners make their own claim to the IRS that they meet the disability exception. With this approach, a financial organization will use code “1,” Early distribution, no known exception, in Box 7 of Form 1099-R. Then the IRA owner will file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with their tax return to claim the exception to the 10 percent early distribution penalty tax.
Either approach is acceptable. Some IRA owners may not like having to file an additional tax form to claim the disability exception. On the other hand, financial organizations may prefer not having to take responsibility for collecting documentation that supports a disability claim—and assessing whether it is sufficient. Weighing the pros and cons, decisionmakers from each financial organization will have to choose which approach to adopt.
