Dear Rick:
I have a problem I hope you can help me with. I just did my tax return, and to my surprise I owe money. Last year I received money from a lawsuit that I was involved in. I never thought that I would have to pay taxes on that money. Unfortunately for me, I confirmed with my attorney that I do have to pay taxes on the settlement. My big problem is I do not have the money to pay the taxes. I have come up with a few options and I hope you can help me pick the right one. My first option is to charge the taxes I owe. My second option is to take a withdrawal from my IRA. My third option is to file an extension and then to pay the tax in October. I have a CD outside of my IRA that matures in the beginning of October. I have enough in that CD to pay my tax liability. My question is which one do you think? One last thing, I am in my early 40s.

Jerry

Dear Jerry:
As far as I’m concerned I really don’t like any of the options. I believe that another alternative would be better for you. First, the reason I don’t like the charge card option is because I believe it is too expensive. Not only do you have to pay fees to the IRS to use your charge card but, in addition, you are going to have to pay interest on your charge card. It would not be unusual for you to pay 18½ percent interest on that money or more. I recognize that it is only until October when your CD matures; however, for those four months it is going to cost you.

I also don’t like the option of taking money out of your IRA, because once again, it is very costly to you. Remember, if you take a distribution from your IRA, not only are you going to have to pay the taxes on the withdrawal, but you’re also going to have to pay a 10 percent penalty. Furthermore, you’ll also lose the opportunity to have money grow tax deferred for your retirement. In other words, it’s a lose/lose situation for you.

Your third option of filing for an extension and then wait for the CD to mature can also be an expensive option. Remember, when you file an extension, it’s an extension of time to file your return, not to pay your taxes. Therefore, not only will you owe the IRS interest but, in addition, more likely than not, the IRS will also assess you a penalty on the amount owed. Once again, this could be an expensive option for you.

As far as I’m concerned, a better option for you would be to cash your CD in now and use the proceeds to pay the taxes. Yes, you may have to pay an early termination fee to cancel your CD; however, in the great majority of cases the penalty will probably be that you will forfeit a few months interest. The interest that you lose on your CD will be substantially less than the interest and potential penalty that you would pay the IRS if you wait for the CD to mature. Using this option, I believe is the least expensive to you, and the one that you should select.

It is not unusual, come tax time, that people find that they owe taxes and they cannot afford to pay them. First, keep in mind that even if you cannot pay your tax liability you should still file your return by the deadline and pay as much as you can. One of the mistakes that people make is that they don’t file their returns and thus, they end up paying unnecessary penalties. If you don’t have other options to pay your taxes, the IRS has a variety of installment plans that more than likely you will qualify for. You can apply online at www.irs.gov/opa or contact the IRS at 1-800-829-1040. The key as far as I’m concerned is to be proactive. It is much better for you if you contact the IRS as opposed to them contacting you. By you being proactive, if there were penalties assessed, you’d have a much greater chance of having those penalties waived as opposed to if they contact you.

I know this sounds crazy but it is true; the IRS can be reasonable to deal with. The key is to be proactive and contact the IRS as soon as possible. By being proactive, more likely than not, the IRS will work with you to come up with a reasonable solution.

Good luck!

Rick is a fee-only financial advisor.  If you would like Rick to respond to your questions, please email him at Rick@bloomassetmanagement.com.
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