Don't tap IRA to pay back taxes
By Sally Herigstad | Published: April 15, 2016
To Her Credit
I'm on disability benefits. After my divorce, I will have $50,000 in an Individual Retirement Account from the divorce settlement. I cashed out my old IRA to buy a small house. I'm 50 years old.
Should I cash out the divorce settlement IRA to pay my back income taxes? I owe taxes for two years straight. -- Emma
I certainly would not drain a $50,000 IRA in one year to pay income taxes. That could be an expensive mistake.
The problem is not the 10 percent penalty for early withdrawal. You don’t have to pay a penalty for distributions taken as a result of disability. The problem is that withdrawals from a traditional IRA are included in your taxable income. When you take a lot out in one year, that money is considered income and could put you in a higher tax bracket, potentially leaving you with a high tax bill.
When you take money out of a traditional IRA to pay taxes and end up with yet another tax bill, that’s not the result you were hoping for!
When your only source of income is disability benefits, you generally will not owe income taxes because you do not have enough taxable income. If you want to take withdrawals from your IRA without losing a chunk of it to income tax, you should take smaller withdrawals and spread those out over a number of years. For example, you may be able to take $10,000 from your IRA in 2016 and still pay little or no income tax. (I suggest using tax software to try “what-if” scenarios before making any withdrawals.)
Another reason you should not take $50,000 from a traditional IRA in one year is that such a large withdrawal may have other unforeseen consequences. The withdrawal will be included in your modified adjusted gross income for purposes of the premium tax credit, for example. In other words, you may not qualify for subsidized health-care premiums in the year you take a large withdrawal from your IRA. (You wouldn’t have this problem with a Roth IRA because Roth IRA distributions are not included in adjusted gross income.)
Cashing in your retirement account is not your only option for dealing with back taxes. You can ask the IRS for temporary hardship relief or apply for an installment plan. Another option is to ask for an Offer in Compromise, which is somewhat like negotiating your debt with the IRS. The IRS may decide that it cannot collect from you, or that it can only collect a much smaller amount than you now owe. In fact, the IRS has loosened restrictions on Offers in Compromise, making it easier for more people to get out from under tax bills they cannot afford to pay. Be sure to get professional tax advice for your specific situation before you attempt an Offer in Compromise.
Your retirement account is for your retirement. It would be a shame to cash in the whole thing at once when you are 50 years old. Try to work out payments or a reduced settlement with the IRS and save the majority of your IRA so you have something to fall back on during your retirement years.
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