Whether through an employer or a qualified IRA plan, most people who have a retirement account understand the importance of managing these funds before retirement age. If worries about becoming a penniless retiree were not enough to encourage people to save, the federal government has implemented some rules that disincentivize early retirement.
If you obtain an early distribution from your retirement plan before you are 59½ years old, you would generally need to pay 10 installments of distribution tax over any regular income tax you may owe. The extra 10% may be called a tax, but it looks and feels like a penalty. The early distribution tax is the cornerstone of the government’s campaign to encourage U.S. citizens to save for retirement, creating another means to prevent people from draining their savings before their golden years.
Except in exceptional circumstances, early participation in a retirement plan can be a bad idea. However, when using your retirement fund is your only option, it is good to know several ways to avoid the additional 10% tax allocated in advance. All people should fully understand the disability rules after age 50 so that they can avoid denials and other hassles when trying to seek benefits while preserving their retirement savings.
The substantially equal recurring payment exception applies to anyone who has an IRA or retirement plan, regardless of their age. In theory, if you start making equal annual installments from your retirement plan, these payments are intended to be distributed throughout your life or your shared life with the retirement plan beneficiary. These payments should not be affected or subjected to an early distribution tax. If you think you may need to take advantage of your retirement plan early, this option may be beneficial for you.
Warning: If you want to start receiving installments from your employer’s plan without being penalized, you would need to terminate your employment before the payment begins. However, if the distribution is from an IRA, your employment status does not matter.
If you are at least 55 years old when you leave your job, you do not need to pay distribution taxes in advance on the distributions you received from your former employer’s retirement plan. (However, you must pay income tax for this.)
This exception is only relevant if you are 55 to 59½ years old. After age 59½, the early distribution tax does not apply to any distribution from the retirement plan. It is important to understand the disability after age 55 rules before taking any action. It may help you avoid complications that threaten your retirement savings.
An employee stock ownership plan (ESOP) is a stock dividend plan that may have certain characteristics of more traditional pension plans. The ESOP aims to obtain funding primarily, or even entirely, from employee-held stocks. However, the ESOP may allow cash distributions, provided that the employee has the right to claim benefits in the employer’s shares.
The dividend distribution of stock held in the ESOP is not subject to early distribution tax, regardless of when you receive the dividend.
If you are paying the assistance rate and compensation of the children from your retirement plan, or if you intend to distribute some or all the plan to your previous spouse as part of a settlement of the property, then none of the options above would apply. It would generally fall under a qualified domestic relation order (QDRO).
A QDRO usually arises from a separation or divorce agreement and contains payments to “alternative receivers,” such as the former spouse or a child. This exception does not apply to IRAs.
If you withdraw money from your retirement funds to pay for medical expenses, part of that distribution can escape the initial distribution tax. But again, the exceptions are not as simple as they sound. The tax exemption applies only to medical expenses that can be deductible. There are additional exceptions, as well.
If you become disabled, all subsequent distributions from your retirement plan can be exempt from the early distribution tax. But what does it mean to be disabled? The law defines a disabled person as being unable to participate in any substantial gainful activity as a result of a medically determinable physical or mental disorder that can result in death or last for an indefinite duration. The key to the disability exception appears to be the persistence of the condition, not its severity.
It also appears that the disability should be treated as a permanent condition at the time of its diagnosis, regardless of whether it is later found to be permanent, even if taxpayers are subsequently eligible for Social Security disability benefits.
Another method of evading the early distribution tax, although unattractive, is by dying before the distribution is completed. After your death, any funds allocated from your retirement plan (for example, allocated to designated beneficiaries) are not subject to early allocation tax, as long as the account is still in your name at the time of the allocation. After your spouse’s death, you can transfer your spouse’s retirement plan or IRA distribution to your IRA or your retirement plan to avoid paying taxes. This benefit only applies to one spouse.
If you are not sure how your withdrawal may affect your taxes or whether you may be eligible for an exemption, it is best to speak with an attorney for Social Security disability who can help you understand your options before you make any decisions. Your lawyer can explain all of the relevant information so that you can understand the do’s and don’ts in the process. People who have reputable legal professionals by their sides can be more likely to avoid unnecessary denials and to receive the benefits they deserve.