Early Withdrawal Penalty

Today TaxMama hears from Cathy in Sunland, CA who tells us, “My husband and I are in our early 40’s. We have managed to get ourselves deeply into credit card debt. I have an old profit sharing plan from an ex-employer that I want to cash out and pay off all our debt. It is $67,000.00. Our annual income is usually in the $100,000.00 range. What are the tax penalties for early withdrawal? We would like to set aside some of the money to pay our taxes next year.”

Well Cathy,

You’ll have to set aside a whole lot of that money to pay your taxes next year. In fact, so much of it, that it’s totally not worth drawing that money at all.

How much you ask?

The penalties are 10% for IRS 2.5% for California. The taxes are 28% for IRS and 9.3% for California.
Total? 49.8% goes to taxes and penalties.

And it gets worse. Drawing this money will move your adjusted gross income so high that you’ll lose some of your itemized deductions, even some of the deductions for your personal exemptions AND it will push you deeply into the Alternative Minimum Tax trap. So, in effect, this money will cost you well more than the 50% in taxes and penalties that I’ve already laid out.

What are some other ways to pay off this crippling debt? Here are some ideas:

If you own a home, either refinance or get a second trust deed with a fixed rate – and use that to bring the debt under control.

If you don’t, own one the two of you are making enough money to qualify for a consolidation loan. Pull all the debt together and spread the payments over 10 years, with no prepayment penalty if you pay it sooner.

As a last resort, start a business. Be sure to show a profit of at least a couple of thousand dollars.
During THIS year, open a solo-401(k) and roll the retirement money into the solo-401(k). If he has any IRAs or other retirement money, you can roll his money into an account for him.

Once that’s done, you’ll be able to borrow up to 50% of the money in each account – up to $50,000 for each of you. You’ll pay yourself back at low interest rates – and there won’t be any taxes or penalty on that money – as long as you keep the business going.

Another benefit of doing this is that the business might make enough extra money to help you pay off that debt sooner.

And remember, you’ll find answers to questions about personal finances and all kinds of tax issues, free. Where? Where else? At TaxMama.com

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