What Happens to Your 401(k) If You Owe Taxes to the IRS?

Summary

Yes, the IRS can take your 401(k) for taxes owed if you fail to pay your taxes in full and on time. The IRS has broad authority to levy assets, including retirement accounts, to collect unpaid taxes. However, the IRS generally only takes this action as a last resort after other collection efforts have failed.

To protect your 401(k) from an IRS levy, it’s crucial to be proactive about your tax debt. Respond to IRS notices promptly and work with the IRS to establish a payment plan if you cannot pay your taxes in full. You may also consider seeking professional help from tax professionals to navigate the process and explore alternative solutions such as installment agreements, partial payment installment agreements, offers in compromise, and currently not collectible status.

If the IRS does levy your 401(k), you have the right to contest the decision and request a hearing. You also have the right to avoid financial hardship caused by the levy by ensuring that the IRS does not seize funds you need for basic living expenses. It’s important to take action as soon as possible to protect your retirement savings from an IRS levy.

Can the IRS Take Your 401(k) for Taxes Owed?

Your 401(k) represents a lifetime of hard work, savings, and planning for retirement—can it really be wiped out by an IRS levy? The IRS has broad authority to levy assets when a taxpayer fails to pay their taxes in full and on time, and that does extend to many types of retirement accounts. Depending on your specific circumstances, this may include your 401(k).

A 401(k) is an employer-sponsored plan that offers significant tax benefits. Although your money grows over time, your contributions grow tax-free—and if you wait until age 59.5 to withdraw funds, you can avoid IRS tax penalties and extra taxes. This is obviously a valuable asset you want to protect—learn more about how the IRS may levy retirement accounts and how you can protect your savings.

Legal Framework Governing IRS Actions

The ability to levy assets is granted to the IRS in the Internal Revenue Code, section 6331. It states that if any person neglects to pay their taxes after notice and demand, the IRS can collect those taxes by a levy placed on all property and rights to property, excluding certain properties listed under section 6334. This broad permission includes your retirement funds.

Differences Between IRS and Other Creditors

In general, the Employee Retirement Income Security Act prevents creditors from taking your 401(k) and other employer-sponsored retirement plans. There are only a few exceptions to this rule, including child support, civil judgments, and federal tax liens.

Circumstances Under Which the IRS Can Access Your 401(k)

While a levy on your retirement accounts is a frightening possibility, note that the IRS generally only goes this route as a last resort. They don’t want to leave taxpayers without retirement funds and the assets they need to make ends meet—however, they may go this route if every other collection action fails.

Generally, the IRS recommends that Revenue Officers attempt to seize other assets before moving on to retirement accounts. The IRS is more likely to approve the seizure of retirement accounts if the taxpayer has been flagrant about their refusal to pay taxes.

What does the IRS consider flagrant behavior. It includes:

• Contributing to retirement account above and beyond automatic contributions while failing to pay taxes
• Tax fraud or evasion
• Assisting others in their attempts to commit tax fraud or evasion
• Owing taxes based on illegal income
• Refusing to submit a Collection Information Statement when requested
• Failing to take actions to reduce tax liability
• Having trust fund recovery penalties assessed against you
• A pattern of uncooperative behavior
• Placing assets beyond the reach of the IRS in order to protect them from seizure

Just as the IRS will consider flagrant behavior as a reason to seize a retirement account, they will also take into account extenuating factors that may make them more lenient. If a taxpayer has had a serious illness, become unemployed, been the victim of identity theft, or lost a loved one, the IRS may be less likely to seize a 401(k).

How Much Can the IRS Take?

The IRS can only take the portion of a retirement account that you can access and have the right to withdraw. If you have funds in a retirement account that you cannot access until retirement, the IRS cannot speed up the process of accessing those benefits in order to pay off your tax debt.

The Process of an IRS Levy on a 401(k)

The IRS must go through a number of steps to seize your 401(k) for back taxes, as is the case with any levy or lien. Before the IRS can take your retirement funds, they must first send you a Final Notice of Intent to Levy and Notice of Your Right to a Hearing. They must then wait 30 days from the date on that notice and then they can seize your retirement assets.

The Notice Process

While the Final Notice of Intent to Levy and Notice of Your Right to a Hearing—LT11 or Letter 1058—is the last notice you receive before your levy, it certainly is not the first. In fact, you will receive several other IRS notices before this one, including CP14, CP501, CP503, and CP504.

Just like your final notice, each of these notices gives you 30 days to respond and either contact the IRS directly or pay your taxes. This means that over a month passes between each notice, so at least four months typically pass between the first notice and the Final Notice of Intent to Levy.

Ideally, you’ll take action some time between the first notice and the last one—the earlier you respond, the more time you have to explore your payment options and decide on the best path for your situation.

Exceptions to These Requirements

The IRS may be able to bypass the notice requirements in certain situations, but these situations are quite rare. If collection of the tax is in jeopardy, they can seize your 401(k) immediately. This may be the case if the taxpayer in question is a flight risk and has the means to flee the country with their assets.

Consequences of a 401(k) Levy

When you withdraw from a 401(k), you are taxed on the distribution. A payment to the IRS to cover past-due tax debt is, unfortunately, considered a distribution. The plan distributor generally withholds 20% to cover taxes, and the IRS only receives the remaining 80%.

However, the good news is that when the IRS seizes money from your retirement account, you are not on the hook for the 10% early withdrawal penalty that applies to most withdrawals before the age of 59.5 years.

Protecting Your 401(k) from IRS Levies

The best way to protect your 401(k) from an IRS levy is to be proactive about your tax debt. We understand it is scary to receive multiple notices from the IRS, and for many people, it’s easier to pretend they don’t exist than to check out their options and commit to a payment plan.

Once you receive the first notice indicating that you have unpaid taxes, you should assume that you are on the path to a levy if you do not make other arrangements to pay off your tax debt. With that in mind, you can respond immediately and begin working with the IRS on a payment arrangement.

The Role of Tax Professionals

Tax professionals play an important role in helping taxpayers avoid 401(k) levies, especially when they have ignored multiple notices and left their IRS response to the last minute. It’s particularly important to talk to a tax attorney if the IRS has assigned a Revenue Officer to your case. While pending cases may languish for some time before the IRS pursues collection actions, the wheels tend to turn much more quickly when a Revenue Officer is involved. In that case, you should take immediate action to find another way to pay off your tax debt.

Alternatives and Solutions for Tax Debts

While the IRS has a reputation for being inflexible and stern when it comes to paying taxes in full, the fact is that they do accept a wide variety of payment options. Their ultimate goal is to collect what is owed; they would rather collect that amount over time or accept a reasonable compromise than collect nothing at all.

If you’ve never had to address unpaid taxes with the IRS before, you may be unfamiliar with the payment arrangements they offer to taxpayers. These options include:

• Installment agreement: With an installment agreement, you can extend your tax payments over a period as long as 72 months and even longer in rare cases. You’ll need to make payments on time every month, avoid letting any other tax debt accrue, and file all of your required tax returns to avoid defaulting on your installment agreement.
• Partial payment installment agreement: A partial payment installment agreement also requires you to make payments every month. However, this option is intended for those who cannot afford the minimum payment required for an installment agreement. Payments only last until the Collection Statute Expiration Date.
• Offer in compromise: Much like a partial payment installment agreement, an offer in compromise is suitable for someone whose income and assets aren’t enough to cover their tax debt in full. Based on your financial information and calculations, you make a settlement offer to the IRS. If they accept it, you pay that amount and the rest of your tax debt is written off.
• Currently not collectible: If you are unable to make payments due to your current financial situation, the IRS may temporarily consider you currently not collectible. This is not a permanent solution unless you remain currently not collectible until the Collection Statute Expiration Date runs out.

Legal Rights and Options

You have the right to contest the IRS’s decision to levy your retirement account; those rights are explained in your Final Notice of Intent to Levy and Notice of Your Right to a Hearing. Note that you have a limited timeframe in which you can request that hearing, so you should act quickly if you want to take advance of this option.

Requesting a hearing stops the IRS from pursuing collection actions, including seizing your 401(k). During the hearing (typically just a phone call with the IRS), you can explain why you don’t want the IRS to seize your retirement account and propose monthly payments or other arrangements.

You also have the right to avoid financial hardship caused by levies. If the funds in your 401(k) include money you need now or will need in the near future, the IRS should not seize that amount. The IRS bases the amount they take based on the cost of living and your basic living costs.

You’ve worked hard to build up your retirement accounts and set yourself up for success in your golden years—don’t let a year of unpaid taxes undo everything you’ve worked for. With the help of the team at Timothy S. Hart Law Group, you can take action, address your tax debt, and avoid a costly levy. Call us at 518-213-3445 or contact us online to schedule your consultation.

Frequently Asked Questions

Can the IRS withdraw money from my 401(k) without notifying me?

In general, the IRS must provide at least 30 days of notice before withdrawing funds from your 401(k). There are limited circumstances under which they can take funds without notice, but those situations do not apply to the vast majority of taxpayers.

What are the implications of an IRS levy on my retirement account?

You’ll lose 20% of the withdrawn amount to taxes, and the overall value of your retirement account in years to come will take a significant hit. Retirement accounts are among the most valuable assets most people have, and losing any portion of them to the IRS can negatively impact your quality of life post-retirement.

Are there any circumstances where my 401(k) is completely safe from the IRS?

If the entirety of your 401(k) will be used by you now or in the near future for necessary living expenses, per the IRS’s calculations, they cannot seize anything. They also cannot take any of it if you are unable to access or withdraw any of it.

If I cash out my 401(k), can it be garnished?

If you cash out your 401(k) and you have unpaid taxes, the IRS may seize the funds while they are in your bank account. If you spend all of the money in your 401(k) before the IRS has the chance to seize it, the agency may not be as willing to work with you on settlements or relief options.

How can I negotiate with the IRS if I can’t pay my taxes?

The IRS is open to negotiations—you can work with them directly or with the help of a tax attorney to set up an installment agreement, offer in compromise, partial payment installment agreement, or request currently not collectible status.

What are the long-term effects of an IRS levy on my 401(k)?

Long-term, you lose out on the potential growth of the amount seized. If you only put the minimum amount required for an employer match, it can take a significant amount of time to make up for that loss.