The Costly 401(k) Mistake Retirees Make When Paying IRS Bills And Why It Backfires

Receiving a tax notice from the Internal Revenue Service (IRS) can be stressful for retirees, especially amid rising living costs, inflation, and risks to the continuity of Social Security benefits.

At a time when millions of Americans rely on Social Security to simply get by, receiving a CP2000 notice from the IRS over a mismatch between tax returns and income reported by third parties could quickly become a financial strain.

While a retiree's first response may be to make the IRS notice go away, they may not have the funds to settle the dues. In such scenarios, many liquidate their holdings in their 401(k)s to write a check to the US Treasury, a move that can have long-term financial consequences.

Note that all withdrawals from your 401(k) are treated as ordinary income. Hence, large withdrawals can push retirees into a higher tax bracket and increase the taxable portion of Social Security benefits, potentially creating additional tax liabilities in subsequent years.

Withdrawing from a traditional 401(k) not only attracts more taxes but also hampers the compounding potential of retirement savings.

IRS Payment Options Without 401(k) Withdrawals

The IRS has a range of payment options for people who can't clear dues in one go. They can opt for installment agreement, enabling taxpayers to repay their debt through manageable monthly payments.

Retirees struggling financially may qualify for 'currently not collectible' status, which will temporarily stop IRS collections if repaying their tax debt would prevent them from covering the costs of essentials. But the debt remains and accrues interest until cleared.

Another option is an offer in compromise, which allows taxpayers to settle the dues for a lower amount. The IRS will accept lower payments if the agency concludes it is less likely to collect the full balance over time. To determine eligibility for this programme, the IRS will scan the income, expenses, assets, and the ability to pay before arriving at a decision. The process can be cumbersome and involves a lot of paperwork.

Overall, retirees should explore these options instead of breaking their 401(k) or ignoring these tax demand letters. The IRS slaps penalties for a while before using other mechanisms, including freezing your liquid accounts, withholding Social Security payments, and placing liens on property, and even garnishing wages to recover dues.

However, IRS guidelines usually prevent agents from going after retirement accounts unless they have tried out all other options. Even then, the agency must consider if seizing retirement funds would cause significant financial hardship.

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