How Does The IRS Structure Payment Plans If I Owe Subjectively High Taxes?

Question

During the 2015 tax year I became legally separated.

During the separation my ex-wife did not agree to a QDRO when cashing out her equity from jointly owned property. The cash out was mandated by our separation agreement which was filed with my state of residence.

As a result, when I made a $40,000 early withdrawal from my 401K to satisfy the equity payment, listed on my 1099-R as a total distribution, I incurred the extra tax penalty. I also filed head of household with 1 child as a deduction, and my income pre-401k withdrawal is too high to qualify for any credits.

My tax bill is higher than I can afford to pay cash with (low 5 digits), and I am trying not to panic. This is the first time I have ever been in a position where I owe taxes and I am unfamiliar with what my options are.

As I understand it, the IRS states that I can establish some kind of payment plan, but economically speaking, what does this involve? Do I have only a certain time period (the tax year) to pay it or is it spread out over time?

What about other options? Should I negotiate somehow to have it reduced, since the withdrawal, in spite of it not being a QDRO, was used exclusively and entirely to satisfy the separation agreement?

I can make the payment if I split it between two credit cards that I have, but that would effectively max me out and could potentially ruin my credit.

I have good credit (upper 700s) and equity in my home that I could use to take out a loan to cover the balance. This to me makes the most sense as I would certainly get a better rate than the penalties and interest the IRS would slap on, but I hate the idea of extending/creating another line of credit.

Are there others I have not considered?

Thank you.

Answer 1

It sounds like you are saying the taxes you owe outweigh your liquid assets. Also without knowing the details, it is a little difficult to give you specific advice. (What was this property you two shared? What are your liquid assets? Also did you share the 401k with your wife and have to split it on the divorce?)

"This is the first time I have ever been in a position where I owe taxes and I am unfamiliar with what my options are." You have to pay them.

Your tax bill is most likely high because of the 401k penalties. It sounds like you had to pay the $40,000 to satisfy the equity payment. It doesn't matter how you got this money, but the fact is you had to withdraw it from your 401k. The government only cares that you withdrew early, and for that you have to pay the penalties.

I feel for you, but it sounds like you may have jumped the gun. You didn't withdraw from your 401k the right way, and without realizing the financial consequences of doing so. So now you have the 10% penalty, on top of the income taxes you now have to pay.

Special tax exemptions for divorcees

How a divorce affects your 401k:

http://finance.zacks.com/early-withdrawal-401k-divorce-6286.html http://www.huffingtonpost.com/jeffrey-a-landers/can-i-take-money-out-of-m_b_835303.html

Ways to withdraw from 401k without penalty:

http://financialducksinarow.com/9471/16-ways-to-withdraw-money-from-your-401k-without-penalty/

It sounds like in divorce, the only way to withdraw from the 401k without penalty is with the QDRO agreement, and that is with the intention of splitting up the 401k as assets to both parties (since you no longer share finances). But if you were awarded the 401k in its entirety, and there was no QDRO agreement signed, the Government just sees it as you withdrawing early for need to access liquid assets (whatever that need may be).

This explains it best: http://www.divorce-finances.com/articles/bid/46343/Providing-spouses-penalty-free-access-to-retirement-funds-in-divorce

From the information you've given, it sounds like you owe somewhere in the $4000-$7000 range in taxes.

I don't think paying with credit cards is a bad option, especially because you will earn rewards, but maxing out could hurt your credit. Honestly though, not paying federal taxes is a lot worse than a temporary ding on your credit score.

If you're still not sure, hire an accountant or tax lawyer to do your taxes with you. They might think of a way to spin the situation in your favor.