401(k) Disability Withdrawal: Requirements, Taxes, Social Security

When you withdraw money from a 401(k) before retirement, you normally have to pay a 10% penalty. One way to avoid the penalty is to take a 401(k) disability withdrawal.

What are the requirements for a 401(k) disability withdrawal?

Under the rules for penalty-free early withdrawals, you must be totally and permanently disabled to use the disability withdrawal option. This generally means that you’re not able to work at all.

If a disability prevents you from continuing your current employment but there are other jobs you can do, you generally aren’t considered disabled for tax purposes.

The rules for 401(k) disability withdrawals are actually more strict than the rules for Social Security Disability benefits. While the requirement that you can’t perform a substantial gainful activity is similar, Social Security Disability generally only requires that your disability be expected to last for at least a year.

So if you’re expected to recover, you may not be able to take a 401(k) disability withdrawal.

Because of those differences in the rules, the fact that you receive Social Security Disability benefits, certain VA benefits, or other types of disability benefits or pensions does not mean that you automatically qualify for a 401(k) disability withdrawal.

Permanent Isn’t Always Permanent

While permanently disabled sounds like a pretty clear requirement, it’s actually not so clear. You may still meet the definition if your disability is of indefinite duration or there’s no guarantee that you’ll recover enough to work.

For example, say you were in a serious accident and will need long-term treatment and rehabilitation. If your doctors believe you will be able to recover and return to work, you may not qualify. If your doctors aren’t sure that you’ll ever be able to work again, you may qualify.

Since there are gray areas, you may want to talk to a tax advisor who specializes in this area. Your tax advisor may also be able to recommend a doctor who’s familiar with evaluating whether you have a permanent disability under the Internal Revenue Service rules.

Required Medical Proof

Before you can take an early distribution for a disability, you generally need to be evaluated by a doctor. The doctor must provide a written statement that you’re permanently disabled and unable to return to work.

The IRS will also accept certain statements from the VA. However, the VA’s evaluation must match the IRS requirements. Some VA disability benefits have less strict requirements than the IRS.

You generally do not have to file your medical statement with your tax return or send it to the IRS. You do need to keep it in your records in case of an audit. This is just like how you need to keep proof for deductions or tax credits you claimed.

Your 401(k) plan provider will normally ask for medical documentation before granting a disability withdrawal. If you don’t provide proof, they’ll usually mark the withdrawal as unqualified and subject to the early withdrawal penalty.

Do you pay taxes on a 401(k) disability withdrawal?

When you take an early distribution due to a disability, the only thing that gets waived is the 10% penalty on early distributions. Federal income taxes generally apply to your withdrawal the same as a 401(k) withdrawal in retirement.

The reason you get taxed is that a 401(k) is considered tax-deferred. While you get a tax break for contributing to a 401(k) while you’re working, you have to pay taxes when you take the money out. The main benefit is that you usually have a lower tax rate when you’re retired compared to when you were working.

State tax rules vary. Some tax all 401(k) withdrawals while others always exempt them. Your state may also have special rules for disability withdrawals.

Ask your tax advisor about the specific rules for your state.

Alternatives to a 401(k) Disability Withdrawal

There are several possible alternatives to a 401(k) disability withdrawal. You may want to consider other options because you don’t qualify for a disability withdrawal or because other options simply work better for you.

• Withdraw funds from a Roth IRA: You can generally withdraw contributions you made to a Roth IRA at any time without owing taxes or penalties. You don’t need a specific reason or any reason at all.
• Take a 401(k) hardship withdrawal: You can take a 401(k) hardship withdrawal for several types of financial hardships without needing to prove that you’re disabled. However, a hardship withdrawal isn’t available if you’re not using the money to pay specified expenses or if you have other funds available.
• Take substantially equal periodic payments: Another option that doesn’t require proof of disability and is common for early retirees is to take substantially equal periodic payments. Using an IRS formula, you can take annual payments that start to pay out your 401(k) before you reach retirement age. The downside to this option is that you usually need to commit to these payments for at least 5 years or until you turn age 59.5.
• Job loss after age 55: If you leave your job for any reason after you turn age 55, you can usually begin taking money out of your 401(k) without penalty. However, not all 401(k) plans support this option.

Talk to your tax advisor to discuss which of these or other options is right for you. You’ll also want to consider things like other sources of income you may have and what your taxable income will be each year.

For example, let’s say you need to take money out of a retirement account this year and will have no other income. You’d usually want to withdraw from a 401(k) or something else that’s taxable. Even though it’s taxable, if you’re in the 0% tax bracket, you won’t actually pay taxes.

And then maybe in a future year, you’ll have taxable pension income so withdrawing from your Roth IRA will be better then.

This kind of tax planning can get complicated when you’re thinking about IRAs, pensions, Social Security, 401(k)s, and other investments plus state and federal taxes. Finding a tax advisor to help you do it right can potentially save you thousands of dollars in taxes each year.

Does a 401(k) disability withdrawal affect your Social Security Disability benefits?

A 401(k) disability withdrawal generally should not affect your eligibility for Social Security Disability or the amount you receive. Social Security Disability generally requires that you can’t engage in substantial gainful activity not that you have no income at all.

What a 401(k) withdrawal of any type can do is make you have to pay taxes on your Social Security benefits.

To determine whether you have to pay taxes you add up

• 1/2 of your Social Security benefits
• Your taxable income — 401(k) withdrawals, IRA withdrawals, pensions, final paycheck, savings account interest, etc.
• Certain tax-exempt income like interest on municipal bonds

If that number is

• Between $25,000 to $34,000 as an individual, you pay income tax on up to 50% of your Social Security benefits
• Over $34,000 as an individual, you pay income tax on 85% of your Social Security benefits
• Between $32,000 to $44,000 as a joint filer, you pay income tax on up to 50% of your Social Security benefits
• Over $44,000 as a joint filer, you pay income tax on 85% of your Social Security benefits
• Any amount when married and filing separately, you will usually pay taxes on your Social Security benefits

The tax you’ll pay is the regular income tax rate depending on your tax bracket.fd