Disability or Termination

[TBob]

A participant terminates from employment prior to age 59.5 but does not take a distribution from the employer's 401(k) plan. Several years later, the participant becomes disabled and would meet the definition under 72(m)(7). He has requested a lump sum distribution of his 401(k). Assume that none of the other exceptions to the 10% penalty apply to his situation.

Which distribution code should we use on his 1099R? Would we use code 3 for a disability or would we use code 1 since the participant was not disabled at the time of termination. I am inclined to use the code that applies at the time of the distribution rather than the code that applied at the time of the distributable event. Your thoughts?

[Nate X]

I believe you could argue this either way (his/her situation at the time of payment vs. the reason for the distribution).

However, even if you use code 1, the participant will still be exempt from the 10% penalty.

[KateSmithPA]

I believe you could argue this either way (his/her situation at the time of payment vs. the reason for the distribution).

However, even if you use code 1, the participant will still be exempt from the 10% penalty.

[KateSmithPA]

This is a very old post, but I have the same question.

Participant terminated in 2002 and did not take a distribution (balance greater than $5,000).

In 2010 participant becomes totally disabled and requests a distribution. Is this distribution exempt from the 10% penalty?

Thank you.

Kate Smith

[Belgarath]

IMHO, yes, the distribution is exempt from the penalty tax. The statute says distribution to an "employee" which the person in your situation clearly isn't, but I don't think you should take a hard line on that basis, since the rest of that section 72(t)(2) refers to "employee" for other exemptions as well - for example, (v) gives the exception to an "employee after separation from service..." and once separated from service the person obviously isn't still an "employee."

[masteff]

Whether to use code 1 or 3 depends on how sufficient your knowledge of the disability is. For example, at my former job, we only used disability if the person became T&P under our LTD plan (can't remember if we'd have accepted Social Security disablity now that I think about it). Even if you use code 1 on the 1099-R (because of insufficient documentation of the disability), the participant can easily file form 5329. (And I'd generally avoid becoming the arbiter of whether the person is T&P so unless you have someone else's opinion to rely on (like an insurance company or the SSA), I'd go w/ code 1 and not get dragged into making a determination.)

[Belgarath]

Reinstating this question because I just had the actual situation come up - participant terminated employment a couple of years ago, subsequently became disabled (within the meaning of the law), and now wants a distribution. Less than 59-1/2, not other exceptions apply.

After looking into it more deeply, I'm even more comfortable with this being an appropriate exception. IRC 72(t)(5) says that for purposes of this subsection, an "employee" includes any participant...

So the 72(t)(2)(A)(iii) exception that refers to "employee" should include a former employee who still has an account, and is therefore clearly a "participant."

If for some reason someone is uncomfortable with this, they could always just roll it to an IRA and take the distributions from the IRA, Seems like an unnecessary step, however.

[masteff]

subsequently became disabled (within the meaning of the law)

I still stand by my previous statement. If you have sufficient knowledge to determine that they qualify as disabled (and hopefully have some sort of documentation for your files) then, yes, use code 3.

I can't think of anyone that I ever paid out under code 3 who had not previously been terminated from employment (generally under long term disability but we had a few qualify under SSA definition). (For what it's worth, I saw a dozen or more disablities in 8 years at a large corporation in retirement plan administration with 4 DBs, 4 DCs, 4500 employees and 1500 terms/retirees.)

[Belgarath]

Masteff - I wasn't disagreeing with you. I was just saying that IF the former employee subsequently becomes disabled (under the requirements of the law and the plan, such as a statement from a licensed physician, or whatever the plan says) that it qualifies for the exception from the premature distribution penalty. The disability didn't have to occur prior to termination of employment.

I agree with your assertion that if the plan doesn't have sufficient documentation/proof that it is a qualifying disability, then they shouldn't report it as such.

My experience with small plans is that the employers are usually pretty loose when requiring "proof" that it is a qualifying disability...

[masteff]

Ah! I thought it was more of a question and was agreeing w/ you.