Wednesday's Tax Tip #15

So far this tax season, I've had two clients take distributions from retirement accounts to cover debt issues.

A word for the wise, avoid doing this at all costs.

First, typically when people take money from an retirement account (IRA's, SEP's, SIMPLE's) they will typically have the payor withhold a flat 20% for income tax. This is just an estimate of the tax consequences not the actual tax on the distribution.

For example, if you are in the 15% tax bracket, you will have 15% in income tax plus an additional 10% excise penalty for the withdrawal. You're effectively 5% under withheld on that withdrawal.

In addition, a particularly large distribution may throw you into the 25% tax bracket, thus resulting in 25% federal tax plus the 10% excise penalty.

But we're still not quite finished, you also have state income tax to pay on said withdrawal. In Ohio, I advise clients to factor roughly 5% for state tax (but it can be as high as 6.55%).

Now, you not only have issues around debt but you also have the compounded problem of a tax debt.

So before you yank any funds from a retirement account you should

1) Analyze your personal financial situation. If you are simply prolonging an eventual bankruptcy filing, don't add to it by creating more debt with a big tax bill. In addition, a bankruptcy attorney may be able to keep those assets from being seized.

2) Talk to an accountant about the actual tax impact of such a withdrawal. You may be able to lessen the tax burden with some effective planning.

3) Be ready to pay the additional tax on any distributions.

During my career, I've seen way too many people add to already stressful financial situations with some unwise handling of retirement accounts. Talk to a professional and avoid the same pitfalls.