Using a 401(k) plan to save for retirement offers substantial income tax benefits to help you build and grow your retirement savings. Contributions aren’t counted as taxable income, and the money grows tax-free as long as it remains in your 401(k) plan. However, to ensure that people are using 401(k) plans to save for their retirement, the IRS tacks on early withdrawal penalties for most distributions from the plan prior to retirement age. If, however, you suffer a long-term disability, you may qualify for an exception to the typical penalties that apply when you tap your nest egg early.
Exemption From Early Withdrawal Penalty
If you take a distribution from your 401(k) plan before you turn 59 ½ years old, you are usually hit with a 10 percent tax penalty on top of any income taxes you would owe on the distribution. However, if you are permanently disabled, the tax code contains a special exemption that allows you to take the money out of your 401(k) plan without paying an early withdrawal penalty.
For example, if you take out $5,000 from your 401(k) plan before age 59 ½, you would usually owe an extra $500 penalty. However, if you qualify as being permanently disabled, you can withdraw the money without having to pay the 10 percent early withdrawal penalty.
IRS Definition of Disabled
The tax code defines someone as 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." To be considered disabled, you must have proof of your disability, such as a certification from your doctor stating that you’re not able to work anymore.
For example, if you sprain your ankle and are on crutches for a few weeks, you won’t be considered disabled. However, if you suffer from a heart condition that makes it impossible for you to work at all, and there is no cure or timetable for you to recover, that could qualify as a permanent disability.
Income Taxes Are Still Due
The exemption for a permanent disability only exempts the 10 percent early withdrawal tax penalty, not any income taxes due on the distribution. So, don’t expect to be able to withdraw all of your money without paying any taxes because of your disability. Instead, make sure you budget for both federal income taxes and any applicable state income taxes.