Do You Have to Pay Taxes on a 401k if Disabled?

Withdrawing funds from a 401(k) plan before retirement age has tax implications, as these savings vehicles are designed for long-term growth. Early access triggers specific tax rules, but a life event like a disability can alter how the Internal Revenue Service (IRS) treats these withdrawals. The rules differentiate between the standard income tax owed and potential penalties, a distinction that becomes meaningful in the context of disability.

Taxation of 401(k) Distributions

When you withdraw money from a traditional 401(k), the amount is considered taxable income, regardless of your age or the reason for the distribution. The funds in a traditional 401(k) are contributed on a pre-tax basis, so the IRS requires you to pay ordinary income tax on the funds when they are distributed.

Separate from ordinary income tax, an additional 10% tax may apply to distributions taken before you reach age 59½. This is known as the early withdrawal penalty and is designed to discourage using retirement funds for non-retirement purposes. An individual younger than 59½ taking an early distribution could face both their regular income tax and this extra 10% tax.

The disability exception specifically addresses the 10% additional tax. It does not eliminate the requirement to pay ordinary income tax on the withdrawal. This distinction is a frequent point of confusion but is central to understanding the tax implications of a 401(k) distribution due to disability.

The Disability Exception to the Early Withdrawal Penalty

The IRS provides an exception to the 10% early withdrawal penalty if you become disabled. However, the definition of disability for this purpose is specific and may be more stringent than criteria used by other agencies or private insurance policies. To qualify for the penalty waiver, the IRS requires that you be “totally and permanently disabled.”

To meet the “totally and permanently disabled” definition, an individual must be unable to engage in any substantial gainful activity because of a medically determinable physical or mental impairment. Substantial gainful activity refers to the performance of significant duties over a reasonable period for pay or profit. The IRS evaluates this based on your specific circumstances, including your education and work experience.

The impairment must also be expected to be of a long-continued and indefinite duration or to result in death. A condition that is temporary or from which medical improvement is expected would not meet this standard. You cannot assume that qualifying for Social Security Disability Insurance (SSDI) or a private disability plan automatically qualifies you for the penalty exception, though it can be supporting evidence.

Information and Documentation to Support Your Claim

To claim the disability exception, you must provide sufficient proof to the IRS. The burden of proof rests on you to substantiate your claim of being totally and permanently disabled according to the IRS definition. You must have the necessary documentation on hand in case of an audit.

A primary piece of evidence is a detailed statement from a physician. This statement should confirm the nature of your impairment and state that it prevents you from engaging in any substantial gainful activity. The physician’s letter must also attest that the condition is expected to last indefinitely or result in death.

Another form of documentation is a determination letter from the Social Security Administration (SSA) awarding you SSDI benefits. While the SSA’s definition of disability is not identical to the IRS’s, a determination that your “medical improvement is not expected” can be persuasive evidence. Gathering these documents before you file your taxes is a good step to support your position.

How to Report the Distribution on Your Tax Return

Once you determine you meet the disability criteria and have your documents, you must correctly report the distribution on your federal tax return. The process involves specific forms and codes to notify the IRS that you are exempt from the 10% additional tax. Your plan administrator will report the withdrawal to you on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

To claim the exception, you must file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. On Part I of this form, you will report your total early distribution amount. You will then enter the same amount as the portion subject to an exception and enter the specific exception code for disability, ’03’, on the designated line.

Completing Form 5329 correctly results in a calculation of zero for the additional tax. The information from Form 5329 is then carried over to your main tax form, the Form 1040. While the total distribution amount is included in your taxable income on Form 1040, the correctly filed Form 5329 prevents the 10% penalty from being added to your total tax liability.