BACK

Expert Q&A

Don’t tap IRA to pay back taxes

Summary

Cashing out IRA may cause you to end up with yet another tax bill

The content on this page is accurate as of the posting date; however, some of our partner offers may have expired. Please review our list of best credit cards, or use our CardMatch™ tool to find cards matched to your needs.

QuestionDear Sally,
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

Answer

Dear 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.

See related: Pros and cons of paying taxes with a credit card, Don’t use 401(k) to pay back taxes

 

Editorial Disclaimer

The editorial content on this page is based solely on the objective assessment of our writers and is not driven by advertising dollars. It has not been provided or commissioned by the credit card issuers. However, we may receive compensation when you click on links to products from our partners.

What’s up next?

In Expert Q&A

How a secured card’s security deposit works

Your deposit acts as your credit line and is refunded once the card is closed and the balance paid off, minus any fees

See more stories
Credit Card Rate Report Updated: September 16th, 2020
Business
13.91%
Airline
15.48%
Cash Back
15.94%
Reward
15.78%
Student
16.12%

Questions or comments?

Contact us

Editorial corrections policies

Learn more

Join the Discussion

We encourage an active and insightful conversation among our users. Please help us keep our community civil and respectful. For your safety, do not disclose confidential or personal information such as bank account numbers or social security numbers. Anything you post may be disclosed, published, transmitted or reused.

The editorial content on CreditCards.com is not sponsored by any bank or credit card issuer. The journalists in the editorial department are separate from the company’s business operations. The comments posted below are not provided, reviewed or approved by any company mentioned in our editorial content. Additionally, any companies mentioned in the content do not assume responsibility to ensure that all posts and/or questions are answered.