The tax code generally assesses a 10% penalty on distributions from qualified plans, including IRAs, before age 59 1/2. But as many advisors and even many clients know, there are a number of exceptions to this rule. The disability exception applies to distributions from employer plans and IRAs, but what exactly does disabled mean under the Tax Code?
The code's definition of a disabled person is actually quite limiting. Many taxpayers have been surprised by the restrictive provision of 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 stipulated by law. Collecting a disability pension is not sufficient to qualify for the exemption.
In a recent case (Simeon E. and Cynthia L. Isaacs v. Commissioner, 2011), the Tax Court ruled that a taxpayer's ongoing business activities and a lack of credible evidence failed to qualify him as disabled, making him subject to the 10% penalty. Simeon Isaacs was a doctor and lawyer involved in several other business ventures. After selling his podiatry practice in 1997, Isaacs worked as a manager at several businesses between 1998 and 2005. In 2001, Isaacs purchased National Candy & Toy. In 2003, he spent about 35 hours a week working for the company.
From 2003 to 2005, Isaacs also ran 24 Karat Systems. He was also a partner in several other businesses and spent a significant amount of time working for them in 2006 and 2007.
Back in 2003, Isaacs took distributions of $342,487, $16,000 and $148,807 from his retirement accounts. In 2005, he withdrew $8,000. Although each distribution was made before he was 591/2, Isaacs skipped the 10% penalty.
In 2009, the IRS challenged his 2003 and 2005 returns, claiming he owed the penalty for all of the distributions. Isaacs contended he was disabled and testified that prior to selling his practice he'd suffered from depression and followed the advice of a psychiatrist who told him to stop practicing "because of its effect on his mental health." Isaacs also said his depression led to a suicide attempt in 2003 that resulted in a week of hospitalization. At the time of the trial, Isaacs was seeing a psychiatrist quarterly.
NOT DISABLED ENOUGH
The court found in favor of the IRS, ruling that he did not meet the Tax Code's definition of disabled. The court noted that the only evidence was his own testimony; there was no testimony from his doctors or medical records substantiating the severity or length of his illness. The court noted that even if it accepted everything Isaacs claimed, he still would not have met the Tax Code definition of disabled. The regulations recognize mental illness, but in such cases the person must be under continuous supervision or institutionalized. Clearly, Isaacs' business activities showed he did not meet the Tax Code definition of disabled, and the court held Isaacs liable for the 10% penalty.
Eugene Dollander, a nurse working for the Department of Veterans Affairs, evaluated a patient in 2004 who died within the hour. As a result of the incident and inquiries that followed, Dollander experienced mental health problems. Months later, he was diagnosed with post-traumatic stress disorder and depression, and was found to be bipolar. As a result, Dollander's doctor recommended that he be placed on light duty, removed from high-stress emergency situations.
Over the next year and a half, Dollander remained at odds with his bosses. In early 2005, he was cited for unsatisfactory work and suspended, and later reassigned to a psychiatric facility in Minnesota. But he did not report to that job, saying it was beyond his capabilities.
A few months later, Dollander sought to retire on disability. That year, he also requested a hardship distribution from his retirement plan and was sent a check for $158,310.42. Later that year, while still working for the government, Dollander began to manage both his family's farm in Minnesota and his own rental properties in Georgia. In April 2006, Dollander officially retired from his government job. Classified initially as retiring voluntarily, his status was changed later to retiring on disability. But just a month after his retirement, he began working for a new employer as a full-time nurse.
When the IRS examined Dollander's 2005 tax return, it took issue with his claim of an exemption from the 10% penalty and the matter went to court (Dollander v. Commissioner, 2009).
The court acknowledged Dollander suffered from mental and physical illnesses and retired under a claim of disability. But the court found that he was not fully disabled and ruled against him.
THE LETTER OF THE LAW
Many workers who've encountered but rebounded from significant illnesses have had tax trouble. Susan Machlay worked at a phone company while suffering from a condition that caused her to miss work frequently. Worried that her absences would get her fired, she resigned and took a lump-sum distribution from her pension plan. Her health improved after a year, and she took a new job at much lower pay. The IRS and Tax Court found Machlay did not meet the requirements for the exemption. (Susan E. Machlay v. Commissioner, 2009.)
Anna Warrington was working as a customer service rep when family problems brought on nervous breakdowns, causing her to lose her job. About that time, she withdrew $80,559 from her retirement plan. Her doctor indicated she was unable to work and MetLife approved one month of disability payments. The following year, her condition improved and she resumed working. The court noted that she was "able to engage in an activity comparable to the one in which she engaged prior to her illness. Unfortunately for petitioners, [the issue] is not whether their family was in need of Ms. Warrington's retirement money due to Ms. Warrington's illness, the question is whether a taxpayer fits within the technical parameters of a particular law." (Anna E. Warrington, et vir v. Commissioner, 2007.)
Steven Dykes worked as a detention officer when he was diagnosed with hepatitis C in the early 1990s, but was able to maintain "excellent physical reserve and stamina" with treatment. In 2002, Dykes began to suffer from fatigue again and quit a year later, when he was 50. That same year he took a retirement plan distribution of $39,087.10. Although he reported the income, he did not pay the penalty. The court ruled: "Petitioner's illness is not a disability within the meaning of section 72(m)(7) because it is remediable and is not indefinite." (Steven A. Dykes v. Commissioner 2007.)
Clients hoping to use the exemption to make retirement withdrawals before they turn 591/2 must consider the Tax Code. Even in cases where they meet the strict definition, clients should obtain written confirmation from several medical professionals, or may risk a visit to Tax Court.
Ed Slott, a CPA in Rockville Centre, N.Y., is an IRA distribution expert, professional speaker and author of several books and a monthly newsletter on IRAs. For more information, visit irahelp.com.
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