Should You Cash Out Your IRA to Pay the IRS?

A retiree with a $30,000 IRS balance and a $90,000 IRA often reaches the same conclusion: take out $30,000 and make the problem go away. It sounds clean.

It rarely is. Taking $30,000 out of a traditional IRA does not produce $30,000 of payment power. And depending on your situation, the IRS may never have been in a position to take that IRA from you in the first place.

The tax on the withdrawal

A distribution from a traditional IRA is included in gross income under IRC 408(d)(1), except for any after-tax basis tracked on Form 8606. The distribution is taxed at your ordinary income rates. To net $30,000 for the IRS, you may need to withdraw considerably more, and the extra withdrawal is taxed too.

If you are under 59 and a half, the 10 percent additional tax under IRC 72(t) generally applies on top, unless an exception fits. Paying the IRS is not an exception. Being levied by the IRS is. See the levy exception to the 10% penalty.

The Social Security ripple

For retirees already receiving Social Security, the withdrawal can also increase how much of your benefits are taxable under IRC 86. In the income range where the formula is phasing in, each dollar of IRA income can pull up to 85 cents of Social Security into taxable income. A $30,000 withdrawal can create considerably more than $30,000 of additional taxable income. The formula is in why retirees owe tax on Social Security.

The same income can also reduce or eliminate the temporary senior deduction for 2025 through 2028, which phases out above $75,000 of modified AGI for single filers and $150,000 for joint filers, and can raise your Medicare premiums two years later through Medicare's income-related surcharge.

Withholding on the withdrawal

For a nonperiodic IRA distribution, IRC 3405(b) provides default withholding of 10 percent, which you can change on Form W-4R. For an eligible rollover distribution from an employer plan such as a 401(k), IRC 3405(c) requires 20 percent withholding unless the money goes directly to another plan or IRA. Neither default is designed to match your actual tax. A retiree who takes $30,000 with 10 percent withheld and sends the rest to the IRS can owe several thousand dollars more the next April. That is a new balance due, created to pay the old one.

Would the IRS have taken the IRA anyway?

Here is the part most people miss. The IRS's own manual restricts levies on retirement accounts. Under IRM 5.11.6.3, a Revenue Officer must consider alternatives, find flagrant conduct, and determine whether you depend on the account for living expenses before levying it. If you are retired, cooperating, and drawing on the IRA to supplement Social Security, a levy is unlikely. See can the IRS levy your IRA in Florida?

That does not mean the IRA is invisible. In an installment agreement or offer in compromise analysis, the IRS counts it. IRM 5.8.5.10 values an IRA at its cash value less the tax and any penalty to liquidate it, or treats it as income if you are retired and need the distributions to live. But "the IRS counts it" is not the same as "you must cash it out today."

The Florida creditor angle

Money inside an IRA is protected from most private creditors by Florida Statute 222.21. That protection does not stop the IRS, but it does matter if you have other debts, such as medical bills, a credit card judgment, or a personal debt left over from an old business. Once you withdraw the money and send it to the IRS, that protection is gone for good. If other creditors are in the picture, weigh them before you drain the one asset Florida law shields from them.

When cashing out makes sense

• You are over 59 and a half, so no 10 percent tax applies.
• The withdrawal will not push you into a much higher bracket or sharply increase taxable Social Security, for example because you can spread it across two tax years.
• Penalties and interest on the IRS debt are growing faster than the account is likely to.
• Your realistic alternative is an installment agreement that would take most of the account anyway over time.
• You will have enough left, with Social Security and any pension, to cover living expenses for the rest of your life.

When it usually does not

• You are under 59 and a half and no exception applies. Consider whether a requested levy under IRM 5.11.6.3 is appropriate instead.
• Your collection statute is close to expiring. Paying now could spend money the IRS was about to lose the right to collect. See the IRS collection statute.
• You qualify for hardship status or an offer. If your income only covers basic expenses and the IRA is what you live on, the IRS's own standards may protect most of it.
• The withdrawal creates a new balance you cannot pay.

A comparison

Questions to answer before you withdraw

1. What is the total federal tax cost of the withdrawal, including the effect on taxable Social Security?
2. Will the 10 percent additional tax apply, and is there an exception, including a requested levy?
3. How much will be withheld, and will it cover the tax on the withdrawal?
4. When does the collection statute expire on each year you owe?
5. Would you qualify for an installment agreement, hardship status, or an offer without touching the account?
6. After the withdrawal, how many years will the remaining balance support you?

If you cannot answer all six, you are not ready to call the custodian. Most of these answers come from your IRS transcripts and a simple projection, and they are worth getting before you make a decision you cannot reverse.

If you do withdraw, pay it the right way

When you make a voluntary payment, you can designate in writing which tax year and type of tax it applies to, under the IRS's payment designation rules in Rev. Proc. 2002-26. Without a designation, the IRS applies the payment in the order it considers best for the government. Designation can matter, for example to pay off the year with the oldest lien first or to fully pay a year that would otherwise generate more penalties. Pay through the IRS's online payment system or by check with the tax year written on it, and keep the confirmation.

If the payment fully satisfies a year with a filed notice of lien, IRC 6325(a) requires the IRS to release the lien for that liability within 30 days. Watch for the release certificate, and request it if it does not arrive.

Spreading the withdrawal

If you decide to use the IRA, timing can cut the cost. Splitting a withdrawal between December and January puts it in two tax years, which can keep each year in a lower bracket and limit the Social Security effect. Asking the IRS for a short-term payment plan of up to 180 days can give you room to do that. Increasing withholding on the withdrawal with Form W-4R, rather than taking the default, avoids a surprise next spring.

Next step

Before you call the IRA custodian, get an estimate of the total tax cost and compare it to your other options. If you want a lawyer to run that comparison against the IRS's own rules, call (813) 229-7100. The firm's guide on setting up an IRS payment plan describes the most common alternative.