Overview

When you submit an Offer in Compromise (OIC), the IRS calculates your Reasonable Collection Potential (RCP) to decide if your offer is acceptable. Retirement accounts are treated as assets that can be used to pay tax debt, but the IRS does not always count the full plan balance. Instead it estimates what could realistically be collected today after taxes, penalties, and plan rules are applied (IRS OIC guidance; Form 656 instructions).

How the IRS arrives at a retirement-account valuation

  • Start with the account balance shown on recent statements.
  • Subtract likely federal income tax on a taxable distribution (for traditional IRAs/401(k)s) based on your marginal rate; include a conservative state tax estimate where applicable.
  • Subtract early‑withdrawal penalties when they apply (10% federal penalty is common for distributions before age 59½, though exceptions exist).
  • Subtract plan surrender fees or employer restrictions (some plans disallow or penalize in‑service withdrawals).
  • For Roth IRAs, the IRS distinguishes contributions (often withdrawn tax‑ and penalty‑free) from earnings (which may be taxable or penalized if not qualified).
  • If assets are illiquid (private equity, employer stock subject to restrictions), the IRS may apply further discounts or request valuation evidence.

This produces the ‘cash value’ the IRS will include in your RCP calculation (see IRS Offer in Compromise page and Form 656 instructions at irs.gov).

Worked example

  • 401(k) balance: $50,000
  • Estimated federal tax (assume 22%): $11,000
  • Early withdrawal penalty (10%): $5,000
  • Collectible value ≈ $50,000 − $11,000 − $5,000 = $34,000

Note: The IRS may use different tax assumptions or allow a lower tax estimate if you can document your likely tax impact. In my practice, accurately documenting tax withholding rates and plan withdrawal rules often reduces the IRS’s assumed collectible value.

Documentation the IRS expects

Include clear, current evidence with your OIC package (Form 656 and the Collection Information Statement/Form 433 series):

  • Recent account statements for all retirement plans.
  • Plan documents or a plan administrator statement showing surrender rules, in‑service withdrawal rules, and employer consent requirements.
  • An estimate from the plan administrator showing net‑distribution (after fees) if available.
  • Proof of your age, Social Security status, and any qualifying exemptions to early‑distribution penalties.

See FinHelp guides for preparing an OIC package: Using Form 656: Preparing an Offer in Compromise Package and Preparing the Financial Statement for an Offer in Compromise.

Common valuation nuances and pitfalls

  • Overlooking taxes: Many taxpayers forget to subtract income tax on taxable distributions — the IRS assumes distributions increase taxable income.
  • Treating Roth accounts as fully protected: Roth contributions are often accessible penalty‑free, but earnings can be taxable or penalized if not qualified.
  • Ignoring plan rules: Employer plan rules can make a 401(k) effectively inaccessible; if you document this, the IRS may reduce or exclude that asset from RCP.
  • Relying on rough math: Use plan statements and administrator letters rather than guesswork.

Practical strategies (professional tips)

  • Get a written net‑distribution estimate from the plan administrator — it often lowers the IRS’s assumed collectible amount.
  • Document exceptions to early‑withdrawal penalties (medical hardship, separation from service after age 55, etc.).
  • If you are in or near retirement, show projected income sources and explain why tapping retirement savings would create unreasonable hardship.
  • Consider whether an Offer in Compromise is the right path — sometimes an installment agreement or currently not collectible status is preferable (see Offer in Compromise: How Asset Valuation Affects Your Settlement).

When the IRS might discount or ignore retirement assets

If you can prove the account is effectively inaccessible (e.g., plan prohibits distributions until retirement and there’s no cashout option), the IRS may apply a substantial discount or exclude the asset from RCP. The decision is fact‑specific and depends on the evidence you provide.

Example scenarios

  • Young taxpayer with a 401(k) and employer restrictions: IRS may apply partial or full discount if plan prevents withdrawal.
  • Older taxpayer with urgent living expenses: Showing that liquidating retirement funds would create immediate hardship can influence negotiated offers.

Common questions

Q: Will the IRS force me to cash out my retirement to pay taxes?
A: The IRS generally expects collectible assets to be considered when calculating an OIC, but it does not seize qualified retirement plans held by employers for collection without following specific procedures. OIC negotiations recognize penalties and taxes, and documentation matters.

Q: How does age affect valuation?
A: Being over 59½ removes the federal 10% early withdrawal penalty in most cases, increasing the collectible value; exceptions and state rules still apply.

Interlinks (related FinHelp articles)

Authority and sources

  • IRS, Offer in Compromise (Form 656) and instructions, and OIC program guidance: https://www.irs.gov/offer-in-compromise
  • IRS Publication and Form pages for retirement distributions and penalties (see IRS pages on IRAs and 401(k) distributions).

Professional note and disclaimer

In my practice helping taxpayers with OICs, careful documentation of plan rules and a conservative, evidence‑based estimate of taxes and penalties materially improves acceptance chances. This article is educational only and not individualized tax or legal advice — consult a qualified tax professional or attorney about your specific situation.