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Taxes on an IRA Withdrawal for a Bankruptcy

Original post by Leslie McClintock of Demand Media

Congress intended individual retirement accounts (IRAs), to be a long-term investment. To discourage the use of IRAs as a short-term savings solution, the government imposes a 10 percent penalty on withdrawals prior to age 59 1/2. But there are certain exceptions for hardship cases. You should always consider carefully whether IRA withdrawals make sense in your specific situation.

Hardship Distributions

The IRS waives the usual 10 percent penalty on early withdrawals in the event of disability or death, and to avoid foreclosure or eviction from your residence. It is also waived if you need to pay for medical expenses for you or a family member in excess of 7.5 percent of your adjusted gross income, to pay for college expenses, or to pay for a down payment of up to $10,000 on a first home.

Taxation

In addition to the 10 percent penalty, you will also have to pay any state income taxes that may apply, and federal income tax of the entire withdrawal amount. The 10 percent penalty applies to the entire amount of the withdrawal, not the amount you receive after tax.

Asset Protection Considerations

IRAs receive substantial protection under federal law -- and sometimes under state law -- against the claims of creditors. If you withdraw anything from an IRA, you may be exchanging an asset that has creditor protection for another item that has no such protection. This means that while your creditor may have a difficult time seizing your IRA, your new asset that you purchase with the withdrawal proceeds could be vulnerable to attachment.

Chapter 7 Eligibility

Chapter 7 allows individual taxpayers the opportunity to have their debts discharged through the bankruptcy process. However, you cannot file under Chapter 7 if your income exceeds the median income in your area. If you take a large distribution from a retirement plan prior to completing the Chapter 7 process, it could compromise your eligibility for Chapter 7 and force you to file under Chapter 13. This chapter governs reorganization, rather than liquidation, and is generally less favorable to debtors, although you will be allowed to keep more assets under a Chapter 13 than you would under Chapter 7. If you are considering withdrawing assets from an IRA while undergoing bankruptcy, be very careful about the timing.

                   

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About the Author

Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.

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