Avoid a Debt Settlement Tax Surprise
Avoid a Debt Settlement Tax Surprise
Reaching a settlement on your debt comes with important tax consequences.
The number of Americans struggling with high debt is increasing, according to the U.S. Federal Reserve. U.S. household debt reached a new record this spring, the central bank said, with the average indebted household owing more than $16,000 on their credit cards.
Seeking debt forgiveness from lenders is one option to try to deal with the burden of high debt. But there is an important tax consequence:
Any amount of cancelled debt is generally taxed as ordinary income.
This can come as a big surprise at tax time, when the relief of having settled a large debt is replaced by the anxiety of owing the IRS money.
Common debt forgiveness surprises
Common examples of when debt forgiveness can create a tax liability include:
- home foreclosures
- car repossessions
- credit card companies forgiving interest owed
- lenders agreeing to reduce or forgive credit card, medical or student loan debt
- lenders decide they can’t collect a debt, or give up trying
Will Payoulater hadn’t been making payments on a $40,000 car loan and woke up one morning to find his driveway empty. The bank had repossessed the car and cancelled the remaining $35,000 balance on his loan. However, due to depreciation and wear-and-tear, the car’s market value was only $20,000 when it was repossessed. Not only is Will down one car, he’ll also have to pay taxes on the $15,000 difference as cancelled debt income.
As you can see in this example, even the calculation of how much debt-forgiveness tax you owe can get complicated. What is the true market value of the car? Was the correct condition of the auto applied to the value? Getting some help from a tax professional can ensure you won’t be overtaxed.
Some exceptions
There are several situations where debt forgiveness is not taxable, including when:
- it happens as part of Chapter 11 bankruptcy
- the debtor is insolvent (i.e. total debt exceeds the value of assets)
- student debt is forgiven as part of an agreement to work certain government and education jobs
If anyone you know is considering a debt settlement or has gone through one, please have them get in touch to work out the potential tax consequences
Avoid the 10% Early Withdrawal Penalty – What every Traditional IRA owner should know
Avoid the 10% Early Withdrawal Penalty – What every Traditional IRA owner should know
While it is not a good idea to tap retirement accounts prior to retirement age, sometimes it cannot be avoided. What can often be avoided, however, is the punitive 10% penalty for early fund distributions. Outlined here are exceptions to the 10% penalty rule for Traditional IRAs.
It is one thing to be taxed on retirement contributions and their related earnings when you withdraw funds from your Traditional IRA, it is quite another when you pay the tax PLUS a 10% penalty for early withdrawal. Need funds prior to retirement and want to avoid the early withdrawal penalty? There are cases when this can be done:
- Medical insurance premiums if unemployed. If you receive federal or state unemployment for 12 or more consecutive weeks, you may pay for medical insurance premiums from your Traditional IRA without paying the 10% early withdrawal penalty. The premiums may cover yourself, your spouse, and your dependents’ medical insurance premium.
- Qualified higher education expenses. You may pay for tuition, books, fees, supplies, and equipment at a qualified post-secondary institution for yourself, your spouse, your child or grandchild from your Traditional IRA without paying the 10% penalty.
- Medical expenses. If you need to withdraw from your IRA to fund medical expenses in excess of 10% of your adjusted gross income you may do so penalty-free.
- First-time home buyer. IRA distributions of up to $10,000 to help pay for the qualified acquisition costs of a first-time home avoid the early withdrawal penalty too. This is a lifetime limit per individual. A first-time homebuyer is defined by the IRS as not having an ownership interest in a principal residence for two years prior to your new home acquisition date. To qualify the home can be for you, your spouse, your child, your grandchild, your parent or even other ancestors.
- Conversions of Traditional IRAs to Roth IRAs. Want to convert your Traditional IRA into a Roth IRA to avoid paying taxes on future account earnings? No problem, this too is considered a qualified event to avoid the 10% penalty.
- You’re the beneficiary. If you are the beneficiary of someone else’s IRA and they die, there is usually an opportunity to withdraw funds without the penalty. Plenty of caution is required in this case, because if treated incorrectly the penalty might apply.
- Qualified reservist. If you were called to active duty after 9/11/2001 for more than 179 days, amounts withdrawn from your IRA during your active duty can also avoid the 10% penalty.
- Annuity distributions. There is also a way to avoid the 10% early withdrawal penalty if the distributions “are part of a series of substantially equal payments over your life expectancy.” This option is complicated and must use an IRS-approved distribution method to qualify.
Some Final Thoughts
- Remember, the above ideas help you avoid an early withdrawal penalty for funds taken out of your Traditional IRA prior to reaching the age of 59 ½. After this age, there is no early-withdrawal penalty. The penalty is also waived if you become permanently or totally disabled or use the funds to pay an IRS tax levy.
- While the above events allow you to avoid the 10% early withdrawal penalty you will still need to pay the income tax due on the withdrawn funds.
- While generally the same, the 10% early withdrawal penalty rules are slightly different for defined contribution plans like 401(k)s and other types of IRAs.
- Before taking any action, call to have your situation reviewed. It is almost always better to keep funding your Traditional IRA until you retire.