A prior member asked:
"For insolvency what is the IRS definition of Interest in 401K and Pensions. This answer determines if I am insolvent. I used 401K loans to settle with credit card companies, so no loans are available. It should not include the total shown, since it includes deferred taxes. If it were available to take out, it would be subject to taxes and penalties.
Also - can legal fees paid to settle the debt be deducted from the COD?"
You're not going to like the answer, I suspect. While your retirement accounts such as an IRA, 401(k), 403(b), pension, etc. is exempt in most circumstances from collection by the IRS, state income tax agencies, and creditors (depending on your state), those accounts ARE INCLUDED in the computation of insolvency for purposes of the exclusion of Cancellation of Debt Income (CODI) from gross income in the year the debt was canceled.
To make matters worse, 100% of the value of the account contributes to your asset total, not just what would be left after paying income taxes on the pre-tax money sitting in the account.
However, the amount of loans taken against the account would also be included in the liabilities section, so you're really only stuck with including the net equity once it hits the bottom line.
Note that not only are the income tax consequences not taken into account, but neither is the 10% excise tax (penalty for early withdrawal) when computing the value of the asset.
Keep in mind that there are several exclusions available for avoiding the 10% penalty, such as liquidating to pay an IRS tax levy/lien. There are others as well, such as first-time homebuyers up to $10k, medical expenses, insurance premiums when you're unemployed, etc.
I do not know about whether the legal fees associated with negotiating the debt settlement would enter into the equation. It would if it were a debt owed to the attorney, of course. But prepaid ones might not. I've always had insolvent clients so that question has never been raised before.
Bottom line to a very long answer (sorry), is that you have to include exempt assets like retirement accounts in the computation for insolvency. Sucks considering those amounts are not available to a creditor seeking to satisfy a judgment, and they are typically exempt assets in Bankruptcy... but the IRS always gets to cheat the system.
I hope that helps.
Jeff
Jeff Johnston, J.D., LL.M. (Tax)
Principal, Johnston Tax Group
Federal and state tax matters
Four Embarcadero Center, 14th Floor
San Francisco, CA 94111-4164
415-294-1040 office
815-642-4117 e-fax
jeff@johnstontaxgroup.com
www.johnstontaxgroup.com
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Mr. Johnston earned his J.D. from John F. Kennedy University, passed the California bar exam, and completed his studies for the LL.M. (advanced law degree) in Taxation from Golden Gate University advanced graduate law programs. Mr. Johnston is a tax practitioner certified by the California Tax Education Council and a real estate broker licensed by the California Department of Real Estate, license #01300481. He passed all necessary IRS exams and anticipates timely acceptance by the Internal Revenue Service for Enrolled Agent (EA) status, which will qualify under Circular § 230 authorizing federal practice before the IRS in audits, appeals, and ultimately the United States Tax Court. Mr. Johnston’s application for admittance to the State Bar is under review by the State Bar Court of California. He currently represents taxpayers before the California Board of Equalization appealing from decisions by the Franchise Tax Board on income tax issues and decisions by the Board of Equalization on state sales tax issues. Mr. Johnston's core business focus includes advising Registered Domestic Partners and same-sex married couples on new tax law; advising distressed property owners on the tax consequences of foreclosures, short sales, or loan modifications; and advising small business owners on the tax benefits of Net Operating Losses carry-backs and carry-forwards offsetting tax liabilities in the profitable years.
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