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Don't use 401(k) to pay back taxes

By

To Her Credit
To Her Credit, Sally Herigstad
Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006). She writes "To Her Credit," a weekly reader Q&A column about issues involving women, credit and debt, for CreditCards.com, and also writes regularly for MSN Money, Interest.com and Bankrate.com, and has guested on Martha Steward Radio and other programs. See her website SallyHerigstad.com for more personal finance tips and free budgeting worksheets.
Ask Sally a question, or read her previous answers in the To Her Credit archive
Question for the CreditCards.com expert

Dear To Her Credit,
I'm considering withdrawing money from the 401(k) plan from my previous employer. My husband owes back taxes and, of course, now that we're married, my name is attached to those. I was wondering if I withdrew it, would the IRS take everything to pay for the back taxes that are owed? -- Cindy

Answer for the CreditCards.com expert

Dear Cindy,
I would be very reluctant to take money from a 401(k) plan prematurely for any reason. It took years to accumulate that money by having it taken from your check one pay period at a time. You need that money for retirement.

If you take the money out now, you will lose 10 percent off the top in early withdrawal penalties unless you qualify for a specific exception. Then, you have to include the withdrawals in this year's income (because you didn't include the income the years you earned it). You could end up paying about a third of the withdrawals in penalties and income taxes. Say you take out $60,000 -- you will only have $40,000 left.

Worse, some people don't realize how the withdrawals will affect their taxes when they take out the money. They withdraw $60,000, spend it, and then realize the following year when they file their taxes that they owe $20,000 or so. How will they pay that?

Taxes, credit, debt and you
Taxes, credit, debt and you

These CreditCards.com articles about taxes, credit and debt will help you navigate tax payment options, tax liability, tax-time identity theft and manage your credit and debt at tax time.

You asked if the IRS could take the money to pay for back taxes your husband already owed when you got married. You are not liable for your husband's income taxes from before you were married. However, from a practical standpoint, you have reason to be concerned. If you take that money out of your safe retirement account and put it in a joint account with your husband, the IRS could take the cash now and leave you to argue about it later. I would rather avoid that scenario altogether.

One great thing about having your money in a retirement account is that it's practically untouchable. When people get too far behind in their taxes, the IRS can empty a regular bank account unannounced. Real estate can have liens attached by creditors. Retirement accounts, on the other hand, are almost impossible for creditors or the IRS to get a hold of.

When you no longer work for an employer, you should move your money out of the company 401(k) plan and into an IRA or other retirement account. Some people end up with multiple retirement plans from all the places they've worked. It's hard to even keep track of them all! An IRA gives you more investing options, and you can contribute to it every year. Contact the administrator of the new plan and ask them how to do a "rollover." Make sure it's a direct rollover to avoid tax complications.

If your husband's tax problems are severe, he should hire a good tax attorney. Yes, tax attorneys are very expensive, but this is a serious problem. Without an expert looking out for your husband's interests, things could get worse. With help, however, your husband has several options to choose from, including setting up an installment plan, making an Offer in Compromise (OIC), or challenging the amount of taxes owed. Tax problems are enormously stressful. They only get worse when they drag on and on. Help your husband take action now so you can put this behind you both.

I've heard too many times about people taking money out of retirement funds, or even "borrowing" it, and then it's gone. The closer you get to retirement age, the harder it is to make up for that loss. Do yourself and your husband a favor, and keep your retirement money for retirement!

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Gary Foreman, New Frugal You columnist Gary Foreman,
"New Frugal You"
Sally Herigstad, To Her Credit columnist Sally Herigstad,
"To Her Credit"
Cathleen McCarthy, Cashing In columnist Cathleen McCarthy,
"Cashing In"
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"Your Business Credit"
Erica Sandberg, Opening Credits columnist Erica Sandberg,
"Opening Credits"

Updated: April 8, 2010


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