Does Disability Allow IRA Distributions to be Tax-Free?

Understanding your Individual Retirement Account (IRA), its tax rules for distributions are essential. In particular, understanding how disability affects them could prove invaluable - in this article we discuss this further and its effects.

Does Disability Allow IRA Distributions to be Tax-Free?

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Introduction to IRA Distribution Taxes

Your tax liabilities on IRA distributions typically depend upon which kind of IRA account you hold traditional or Roth. In general, traditional IRA contributions qualify for tax breaks when contributed but must pay income tax upon withdrawal; on the other hand, Roth IRA contributions made with post-tax income allow qualified withdrawals tax-free - however certain situations such as disability could alter this rule.

Disability Relief

The Internal Revenue Service allows certain exceptions whereby Traditional IRA early withdrawal penalties do not apply, including being "totally and permanently disabled", according to their definition. As such, taking an early distribution due to disability could potentially help avoid paying the 10% early withdrawal penalty.

Note that although the 10% penalty has been removed from any distribution you receive, ordinary income tax still applies and will be levied at your regular income tax rate. The distribution will become taxable income for that year and be taxed accordingly.

Definition of Disability

According to IRS standards, an individual is considered "totally and permanently disabled" when they cannot engage in any substantial gainful activity due to physical or mental conditions that have an expected long-term outcome such as death or long-term indefinite duration. Due to IRS' strict interpretation, it's imperative that any claim meets this threshold for approval.

Roth IRAs and Disability

For Roth IRAs, the rules vary slightly. Withdrawals should generally be tax-free provided your account has been open for at least five years and its owner reaches age 59 1/2 or later; if however you qualify as disabled according to IRS definition you may withdraw without incurring the 10% penalty even before turning 59 1/2; provided it had been open at least five years, distribution should also be tax free.

Reporting Your Distribution

When receiving an IRA distribution due to disability, it must be reported properly on your tax return. Traditional IRA owners will require filing IRS Form 5329 with their custodian to claim exemption from early withdrawal penalties; and once completed they should also receive Form 1099-R from them showing how much of an amount was distributed which must also be reported as income on tax forms.

Conclusion

As soon as you become disabled, it is vitally important that you understand how IRA distributions will be taxed. While disability may exempt you from paying early withdrawal penalties on both Traditional and Roth IRAs, ordinary income taxes still apply when withdrawing distributions from Traditional IRAs. Due to all the complex details involved with disability-related IRA distributions, seeking advice from someone familiar with them - either tax professional or financial advisor can ensure compliance with IRS rules while potentially saving unnecessary taxes and penalties for distributions from Traditional IRAs.