Owe Money on Your Tax Bill? Think Twice Before Tapping Into Your 401(k)
Tax season can be especially painful if you end up owing money to the IRS — and if you owe more than you had set aside (or if you neglected to set anything aside), figuring out how to pay your tax bill can be daunting. While you may be tempted to withdraw money from your 401(k) to pay what you owe, this probably isn’t the best idea.
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Here’s why experts say you should think twice before tapping into your retirement savings to pay off your taxes.
You’ll Be Penalized — Twice
Taking money out of your retirement account, specifically, if you are not yet at retirement age, will cost you both in the short term and the long term.
“It is generally a bad idea to take money out of your 401(k) — or any tax-deferred account — to pay bills, especially if you are younger than 59 ½,” said Jean A. Wilczynski, CFP, senior wealth advisor at Exencial Wealth Advisors in Old Lyme, Connecticut. “That is because (1) you will owe taxes and a 10% penalty (if you are younger than 59 ½) and (2) you will reduce the amount you ultimately have available when you do eventually retire.”
And how much you lose out on for your retirement is actually more than the amount you withdraw, because that money would have otherwise grown over time due to compounding interest.
“Taking from your retirement nest egg is robbing your future self in lieu of today’s needs,” said Andrew Meadows, SVP at Ubiquity Retirement + Savings. “While dipping into your savings will help your short-term goals, it is because of compound interest that your savings can continue to grow. Remember, your retirement savings are for your comfort and safety at retirement. By focusing on that, your future self will thank you!”
What To Do Instead
If you must resort to using your retirement savings to pay the taxes you owe, it’s better to take out a loan than to make a withdrawal, Wilczynski said.
“If your plan allows for a loan against your balance, taking a loan may be slightly better than an early withdrawal, but you may not be allowed to participate in the plan or receive your company’s matching contributions until you’ve paid back the loan,” she said. “You should review the plan rules closely to be sure you understand what is allowed and what is required for loan repayment.”
Another option is to pause your 401(k) contributions and put those funds toward what you owe to the IRS.
“This will provide an increase to your take-home pay that may help you pay your tax bill,” Wilczynski said. “If you do this, be sure you set a reminder to restart once you’ve achieved the tax bill payment goal.”
You should also look into setting up an installment payment plan with the IRS, if possible.
“You will end up paying interest and penalties for not making an on-time tax payment, but that may be the best option and may help you avoid a tax lien or levy action,” Wilczynski said. “The interest and penalties paid to the IRS are likely to be lower than the taxes and penalty on an early withdrawal from your 401(k) or IRA.”
To set up a payment plan, fill out Form 9465 for an Installment Agreement Request.
“This can show that you’ve got the intent to pay, but don’t have all the funds to do so right now,” Meadows said. “While this might extend the payment process, it can help you in the short term by making the payments much easier to budget around. While taxes feel overwhelming at times, there are ways the federal government understands an individual’s needs and provides assistance to help.”
If you need additional help figuring out how to pay your tax bill, consider meeting with a professional.
“Financial advisors or CPAs can be incredibly helpful,” Meadows said.
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