Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.
Friday, July 10, 2015
Diabetes, Disability And A Penalty
I have a
friend who damaged his back, leading to nerve complications which have greatly
affected his ability to work. Granted, he can still work, but not with the same
intensity as before and certainly not for as many continuous hours. Sometimes
by midday he has to take pain medications, which tend to knock him out. It is
an unfortunate cycle, and the impact on his earning power is significant.
about disability. Then let’s talk about a disability exception to a penalty.
disability income taxable or nontaxable?
this discussion to a disability policy purchased from an insurance company, omitting
coverage from workers compensation and social security. There is a rule of
thumb that is very important when thinking about disability insurance:
you deducted the insurance, then payments under the insurance are taxable.
that you purchased a short-term disability policy through your cafeteria plan.
Amounts run through a cafeteria plan are generally not taxable to you. That is the
point of the cafeteria, after all. Collect on the policy, however, and you trigger
the above rule.
consequence, just about any financial or tax advisor will tell you to pay for disability
insurance with after-tax dollars. The issue becomes even more important when
purchasing long-term disability, as you would be permanently disabled (however
defined) should you collect. You do not need the tax burden at the same time that
your earning power is compromised.
recall that there is a 10% penalty if you take monies out of your 401(k) or IRA
early. Early has different meanings, depending upon whether it is an IRA (or
IRA-based) plan or a qualified plan. You can take money from a 401(k) at age 55
without penalty, for example, if you no longer work for the employer. An IRA
does not care about your employer, but it does make you wait instead to age 59
½. Take a distribution before those ages and you are likely facing a penalty.
But there is
an exception to the 10% penalty if you get disabled.
that you are injured enough to collect disability. Will that count for purposes
of avoiding the 10% penalty?
think so, right?
about the Trainito case.
worked with the Boston Department of Environmental Health (DEH).He was diagnosed with type 2 diabetes in
2005. He unfortunately did not take good care of himself, and he had continuous
and increasing issues with neuropathy. He worked for DEH until October 2010,
when he resigned due to the diabetes. He did not pursue disability benefits
from DEH. Perhaps they did not offer such benefits.
stopped taking his meds.
six months. Trainito took a retirement distribution of over $22 thousand in
later he was found at his home in a diabetic coma. He was taken to a hospital
where he spent more than a month recuperating, leaving the hospital in late
July 2011. Damage was done, and he had reduced use of an arm and leg. He then
applied for disability benefits with the state.
preparing his return for 2011 he claimed the disability exception to the 10%
penalty on the retirement distribution. The IRS disagreed, and the two found
themselves in Tax Court.
section at play is Sec 72(m)(7):
(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 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
the Secretary may require.
reading, it seems to make sense. Introduce an attorney and a couple of non-immediate
(1)The disability must be “total.”
This is a rewording of “unable to engage in any substantial gainful…” This is not an
insignificant requirement, as it does not look to one’s regular and primary employment.
Many private disability policies will find you disabled if
you are unable to perform your own occupation. The IRS definition is much
stricter, requiring one to be unable to reasonably perform almost any occupation. As a consequence, it is
possible that someone may be considered disabled by his/her insurance company
but not considered so by this section.
(2)The distribution must be attributable
to the disability.
The clearest way to show this is to take the distribution
after being medically adjudged as disabled. Trainito did not do that. It is
extremely likely that he knew he was seriously compromised by his diabetes, but
he had not obtained a medical signoff to that effect.
before the Court was whether the absence of that medical signoff was fatal.
acknowledged that “substantial gainful activity” can be impaired by progressive
diseases, such as diabetes. The Court further clarified that the presence of an
impairment (such as diabetes) does not necessarily mean that an individual is
disabled as intended under Sec 72(m)(7).
COMMENT: Makes sense. Odds are we each know someone who is
diabetic but has it under medical control.
provided the Court with the record of his six weeks in the hospital, from June
through July, 2011. He was in a coma for
most of it.
wanted records back to April, 2011, when Trainito took the distribution.
testified that he saw a primary care doctor twice a month after being diagnosed
in 2005. He stopped that when he was no longer working at DEH.
The Court sniffed:
Thus the fact that petitioner suffered a diabetic coma on
June 12, 2011 does not indicate whether he was disabled on April 22, 2011. Petitioner
undoubtedly suffered from diabetes on April 22, 2011 but he has not provided sufficient
evidence to show that his diabetes caused him to be disabled within the meaning
of section 72(m)(7).”
This seems a
bit harsh. There is a “duh” element considering that he has a progressive disease. Perhaps if Trainito
had his doctor testify, perhaps if he introduced his earlier medical records …
did not have his doctor testify nor did he provide his earlier medical records.
Why? Who knows. I suspect there may have been a financial consideration, but
the Court did not say. It is also possible that he thought his testimony,
accompanied by his shortly-thereafter month-long coma, would be sufficient
proof to the Court.
Court concluded that Trainito did not meet test (2) above: he did not show that
the distribution was attributable to the disability. Trainito owed the penalty.
What are my
tax is not just about Code sections and Regulations. Sometimes it is about
facts and – more importantly – being able to prove those facts. I believe you
when you tell me that you donated multiple rooms of furniture to charity when
you moved, but you still need receipts and documentation. I believe you when
you explain how you supported your children from a previous marriage, but I
still need to review the divorce decree and related legal paperwork to determine
whether you can claim the children as dependents.