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?

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.

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

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."

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.)