When a taxpayer becomes disabled before they reach age 59-1/2, the taxpayer can receive a distribution from a traditional IRA or qualified pension plan and not be subject to the 10% additional early withdrawal penalty. In order to be considered disabled, the taxpayer has to be able to furnish proof that they cannot do any substantial gainful activity because of some physical or mental condition. This physical or mental condition must be determined by a physician to be something that the taxpayer will have for the rest of their life or for a long, continued and indefinite period. It cannot be condition that the taxpayer can reasonably be expected to recover from or a condition that is a physical handicap but does not prevent the individual from engaging in gainful activity. A distributions from an IRA or a pension plan to a taxpayer that has been made due to their Disability is fully taxable to the taxpayer unless the owner had made non-deductible contributions to the IRA or other non-deductible contributions to a pension plan. However, such a distribution is not subject to the 10% early withdrawal penalty, regardless of the age of the taxpayer.
A distribution that has been made to an individual as a result of their disability, should be reported to the taxpayer on a Form 1099-R – Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. To enter this distribution into Keystone Tax Solutions Pro, from the Main Menu of the Tax Return (Form 1040) select:
Income Menu
- IRA, Pension Distributions (1099R, RRB-1099-R)
- Select New and enter whether the Payee on the 1099-R is the Taxpayer or Spouse
- Enter the Payer EIN, Name and Address,
- Enter the Gross Distribution in Box 1 as it is shown on the 1099-R.
- Enter the Taxable amount in Box 2a. Normally it is the same as Box 1.
- Enter the Distribution Code in Box 7 as follows:
- if the Code is 3, the 10% Additional Tax for Early Withdrawal does not apply and no further action is necessary upon exiting this 1099-R menu.
- If the Code is 1 or 2, the program will prompt to select a Form 5329 Transfer Option. Because the distribution is from a pension plan or IRA, the transfer option should be “Transfer 1099-R Box 2a to Form 5329, Part I, Line 1”. After this you will be queried, “Does the Amount being Carried to Form 5329 Qualify for Any Penalty Exclusion?” If the taxpayer is claiming an exclusion from the 10% Additional Tax for Early Withdrawal due to Disability, answer this question YES. Select exclusion #3 – Due to Total and Permanent Disability, and enter the amount that was reported in Box 2a that qualifies for an exclusion due to disability.
No further action is necessary upon exiting this 1099-R menu and Keystone Tax Solutions Pro will transfer the amount to be excluded from the 10% Additional Tax for Early Withdrawal on Form 5329. The program will also transfer the taxable amount of the gross distribution to Line 4b of the tax return (Form 1040).
NOTE: This is a guide to entering a distribution reported on Form 1099-R into Keystone Tax Solutions Pro when the taxpayer is claiming a Disability exemption. This is not intended as tax advice.
Additional Information:
Publication 575 – Pension and Annuity Income
Publication 590-B -Distributions from Individual Retirement Plans