A Misunderstanding of the Early Withdrawal Penalty for Disability Applicable to the TSP and IRAs

The exception to the 10 percent early withdrawal penalty for disability applicable to Thrift Savings Plan (TSP) participants and to IRA owners is a source of much confusion and misunderstanding. This column examines when a TSP participant and an IRA owner can make penalty-free withdrawals from their TSP and IRA accounts, respectively.

TSP Early Withdrawal Penalty Tax

If a TSP participant receives a distribution or withdrawal form his or her TSP account (both the traditional and the Roth TSP) before reaching age 59.5, the participant may have to pay an early withdrawal penalty equal to 10 percent of the amount distributed or withdrawn. This penalty is in addition to the regular income tax that has to be paid. The additional 10 percent tax does not apply to:

• Payments made after a TSP participant separates from service during or after the year he or she reaches age 55 (traditional TSP only).

• A public safety employee, as defined in section 72(t)(10)(B)(ii) of the Internal Revenue Code, who receives traditional TSP payments after separating from service as a public safety employee during or after the year he or she reaches age 50 with 20 years of service, or at any age with 25 years of service.

• Up to $5,000 of any payment received within one year following a birth or qualified adoption, in accordance with section 72(t)(2)(H) of the Internal Revenue Code.

• TSP annuity payments.

• Payments resulting from death.

• Payments made from a beneficiary TSP account.

• Payments made to a TSP participant with a terminal disease.

• Payment year is the year in which a TSP participant has deductible medical expenses that exceed 7.5 percent of the participant’s adjusted gross income.

Note the following with respect to TSP payments resulting from total and permanent disability and payments made to a TSP participant with a terminal disease: The TSP states that it cannot certify to the IRS that the TSP participant requesting these payments meets the early withdrawal penalty exemption when the participant files his or her federal income tax return. That means that the TSP participant must be prepared to provide justification in the event of IRS audit.

The Internal Revenue Code has a strict definition of “disability.” The definition is clarified in Internal Revenue Code Section 72(m)(7):

“Meaning of disabled. For purposes of this section, 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 physically 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 the Secretary of the Treasury may require.”

The implications of this strict definition of disability means that simply retiring from federal service “on disability” or collecting a disability benefit does not necessarily qualify a TSP participant for the disability penalty exception. There are various levels of disability which are revealed in the following actual IRS case which was settled in the US Tax Court:

Eugene Hollander was a federal employee. He retired from federal service on a disability retirement before his 55th birthday. He took a distribution from the TSP and claimed the disability exemption from the 10 percent early withdrawal penalty. The IRS disallowed the exemption from the 10 percent penalty. In Eugene Hollander versus IRS Commissioner (Tax Court Memo 2009-187, dated August 19, 2009) the Tax Court agreed with the IRS’ disallowance of the penalty exemption. The reason: After Mr. Hollander retired on disability retirement, he subsequently took another full-time job.

Federal employees who want to retire on a disability retirement should be advised:

• They must apply for and qualify for disability retirement.
• There is no minimum age requirement for disability retirement.
• They must apply for Social Security disability benefits. However, if they do not qualify for Social Security disability benefits, they can still qualify for federal disability retirement, and
• Qualifying for federal disability retirement does not automatically imply an exemption from the early withdrawal penalty from the TSP if an employee retires before age 55.

IRA Early Withdrawal Penalty Tax

If an individual takes an early withdrawal from an IRA (traditional, SEP, SIMPLE, or Roth) and does not rollover the full amount, the amount not rolled over potentially is subject to a 10 percent early distribution additional tax. An early withdrawal is a distribution of cash or property from the IRA before the IRA owner reaches age 59.5, unless an exemption applies. The additional tax applies to the part of the distribution that must be included in gross income and is in addition to any regular income tax on that amount. IRS Form 5329 (Additional Taxes on Qualified Plans Including IRAs and Other Tax-Favored Accounts) must be filed to report the early distribution and calculate the tax.

Distributions before an individual becomes age 59.5 are exempt from the additional tax if they are attributable to his or her being disabled. An individual is considered disabled in the individual can furnish proof that the individual cannot do any substantial gainful activity because of a physical or mental condition. A physician must determine that the individual’s condition can be expected to result in death or to be a long, continued and indefinite duration.

Substantial gainful activity means the activity, or a comparable activity, in which the individual customarily engaged in before the disability arose, or before retirement if the individual was retired when the disability arose.

While all factors must be considered, the following are considered to prevent an individual from performing substantial gainful activity:

• Loss of use of two limbs.
• Diseases of the heart, lungs or blood vessels that have resulted in major loss of heart or lung reserve as evidenced by x-ray, electrocardiogram or other objective findings.
• Cancer that is inoperable and progressive.
•Damage to the brain or a brain abnormality that has resulted in severe loss of judgement, intellect, orientation or memory.
• Mental diseases requiring continued institutionalization or constant supervision of the individual.
• Permanent and total loss of speech, or
• Total deafness uncorrectable by a hearing aid.

Note the following:

1. An impairment that can be corrected is not a disability for the purpose of an individual not being able to engage in “substantial gainful activity.”

2. An individual is not disabled if, with reasonable effort and safety, the impairment can be diminished to the point that the disability will not prevent the individual from engaging in the individual’s customary or any comparable “substantial gainful activity.”

3. With all these conditions, a physician would have to certify that an individual has one or more of these conditions which are expected to last, and

4. While conditions are used to determine if an IRA owner qualifies for the 10 percent withdrawal penalty from the IRA, these same conditions apply for TSP participants who qualify for FERS disability retirement and are making pre-age 55 withdrawals from the TSP.

Those federal employees who are considering retiring from federal service under a disability retirement should be prepared for a lengthy process in order to be approved for FERS disability retirement. If approved for FERS disability retirement, they are advised to speak both to a tax professional regarding the taxation of FERS disability benefits and to financial advisor to determine whether they can realistically afford to retire when they are in their 40’s and 50’s – with or without being subject to an early withdrawal penalty when withdrawing from their TSP and IRA accounts.