Disabled and Cashing Out 401K

[JustMeUC]

A neighbor who owns a commercial rental property beside us was talking last night about her financial situation. She was in a horrible accident last year and has been unable to work since. She applied for Social Security permanent disability which she just won. She will begin receiving $1100 a month starting February of next year, there is some kind of waiting period before she starts getting benefits. Anyway, She now has 5 more months before receiving the disability payments and makes about $800/month from her rentals and she has completely drained her savings. She said she has around $25K in a 401K and was talking about rolling it directly over to a IRA and then cashing it out. I told her that I didn't think she could open an IRA since she had no income this year, that Rental income does not qualify you... is that correct? She seemed to think that was a better option that just cashing out the 401K directly. I just don't know why?? She tried to explain it but it made no sense to me.

Since she is permanently disabled does she get a break on the 10% penalty? She seems to think so but I think I read that you had to have the IRA open for at least 5 years, but now I can't find anything to that effect.

She is not good on computers and I told her I would look around on the internet but have found very little. Any knowledge or advice to pass on?

 

[Alan]

I don't believe you need to have earned income to open an IRA and do a rollover from a 401k. (a rollover is different from making a contribution).

However, if she wants to withdraw the money I would first contact the 401k provider directly and ask about the rules regarding hardship withdrawals. This may be easier than doing a rollover followed by a hardship withdrawal from the IRA.

see link below for some info.

Retirement Plans FAQs regarding Hardship Distributions

PS

Hardship withdrawals avoid the 10% tax penalty

 

[LOL!]

Will she be 55 or older this year? When did she stop working for the employer associated with that 401(k)? Can she borrow from the 401(k) instead of withdrawing?

 

[JustMeUC]

She is in her early or mid 40's. She left there last summer, not sure the exact dates but it was after the accident. She seems determined to transfer the money to an IRA instead of doing it directly with the 401K. She must have her reasons, but I really didn't get it. Perhaps she doesn't want the employer to know she is cashing out but just won't come out and say that.

 

[Alan]

She should be able to do a rollover to an IRA with no taxes.

Since she is disabled then she should be able to make penalty free withdrawals from the IRA.

However, she should first talk to the receiving IRA company before she does the rollover to clarify all this.

 

[rothlev]

She is allowed to rollover the money into an IRA, and if she meets the totally and permanently disabled criteria the withdrawal will be free of penalty. She needs to be careful of the federal tax, thou. Taking a lump sum will increase her AGI, and her social security could become taxable, her tax rate could go up, and she might get an ugly surprize. Worth the trouble to look closely at all the numbers to see the tax ramifications. ( and perhaps split up the withdrawal over more than one year. )

 

[Gabieta]

If she is permanently and totally disabled, she can absolutely take an exception to the 10% penalty on a qualified retirement plan withdrawal.

IRC section 72(t)(2)(A)(iii) allows exception to the 10% penalty due to total and permanent disability. -- Normal income tax will still apply.

For taxes, this requires filling out a form 5329. Code 03 indicates permanent disability.

As a anectdotal note -- I am a volunteer tax preparer, and so far have used this code twice for different clients. Both received nasty IRS letters a couple of years later, that when answered with doctor's documentation of the disability, were ruled in favor of the taxpayer.