By Andy Ives, CFP®, AIF®
There are a number of ways an individual can avoid the 10% early withdrawal penalty from their IRA or employer work plan. Some exceptions apply specifically to IRAs (i.e. higher education; first-time home buyer, etc.) and others pertain only to company plans (for example, the age-55 exception and qualified domestic relations orders, among others). As long as the account holder meets the definition of the exception and files proper paperwork, the IRS will allow penalty free-withdrawals.
While death is the most severe, there is another exception that applies to both IRAs and company plans that seems to loom over all others: Disability. Whether or not someone is disabled is highly subjective. However, when it comes to avoiding the 10% early withdrawal penalty by claiming the disability exception, the definition is strict, and it is clear.
From Tax Code 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. 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.”
The key phrases being: “…ANY substantial gainful activity,” and “…which can be expected to result in death.”
A warehouse forklift operator breaks an arm and leg during a workplace accident. He is incapable of operating large machinery and collects a disability pension. Is he “disabled?”
A minor league baseball pitcher loses a finger on his pitching hand. He can no longer compete for a spot at the highest level and is cut from the team. Is he “disabled?”
A woman allows her business to fall into disrepair as a known side effect of her medication drives her to compulsively gamble away IRA retirement dollars. Is she temporarily “disabled?”
Could the warehouse forklift operator competently fill a desk job? Probably.
Could the former baseball pitcher become a coach? I think so.
Could the woman who gambled away retirement dollars switch medications and get control of her obsessive habit? Yes. In fact, this is a true story. In a recent Tax Court case (Kathryn J. Gillette and Raif Szczepanski v. Comm., TC Memo 2018-195, November 20, 2018), a woman withdrew over $100,000 from her IRA, paid the taxes due, and claimed “disability” to avoid the 10% penalty. The Courts rejected her argument. Any impairment she had was “remediable and not a disability.” Since she was able to recover, she was not “disabled” at the time, no matter how long her dangerous meds compelled her to gamble.
According to the Tax Code and based on the described injuries, none of the above would qualify as “disabled.” Assuming no other exception applied, all would be subject to the 10% early withdrawal penalty if they withdrew funds from their respective IRA or company plan. A word to the wise – be sure the exception you use is permissible for the account you withdraw from (IRA vs. employer plan) and, when it comes to accessing retirement dollars, recognize the definition of “disabled” is a severe and high hurdle to clear.