Estimated tax, catchup withholding and penalties

[mamadizzy]

"Withdrawing taxes owed from one's 401K at the end of the year, since it is treated as ongoing withholding, was a technique I learned here that has served me well."

Can anyone explain what exactly this refers to? Thanks

 

[Gumby]

"Withdrawing taxes owed from one's 401K at the end of the year, since it is treated as ongoing withholding, was a technique I learned here that has served me well."

Can anyone explain what exactly this refers to? Thanks

You not only have to pay the IRS the full amount of taxes owed, you need to pay it evenly through the year. Most people accomplish this through withholding from a paycheck, but if you are retired and getting money from investments, you need to make estimated tax payments four times per year.

If you owe the IRS more than $1000 in taxes and did not withhold or pay as estimated taxes more than 90% or 100% (depending on your income) of the amount of your tax owed last year (the so called "safe harbor" amount), you will be subject to an underpayment penalty by the IRS (in addition to the taxes due).

Suppose it is getting close to the end of the year and you realize that you are going to owe the IRS $3000 next April and are not within the safe harbor.. You cannot solve the problem by making a $3000 estimated tax payment by January 15th, because the tax needs to be paid when required through the year, not at the end. It can be complicated, but let's just say you should have paid $750 on each of the estimated tax dates. Even if you paid $3000 on January 15, 2023, you will still owe penalty interest on each of the $750 amounts you didn't pay on April 15, June 15 and September 15, 2022.

The way to solve your problem is to take money from your tIRA before the end of 2022. In this case $3000. But, instead of you getting the money, you direct the custodian to withhold it all for federal taxes. (I ignore state taxes for the sake of this illustration). Unlike estimated taxes, withholding is considered to occur evenly throughout the year. So you will not face penalty interest for failure to properly pay estimated taxes.

When I was working and saw near the end of the year that I would owe a large tax bill, I would get my payroll department to jack up my wage withholding in November and December to cover it, for exactly the same reason - withholding, even if done in the last month of the year, is considered to have occurred evenly through the year.

 

[OldShooter]

You not only have to pay the IRS the full amount of taxes owed, you need to pay it evenly through the year. Most people accomplish this through withholding from a paycheck, but if you are retired and getting money from investments, you need to make estimated tax payments four times per year.

If you owe the IRS more than $1000 in taxes and did not withhold or pay as estimated taxes more than 90% or 100% (depending on your income) of the amount of your tax owed last year (the so called "safe harbor" amount), you will be subject to an underpayment penalty by the IRS (in addition to the taxes due).

Suppose it is getting close to the end of the year and you realize that you are going to owe the IRS $3000 next April and are not within the safe harbor.. You cannot solve the problem by making a $3000 estimated tax payment by January 15th, because the tax needs to be paid when required through the year, not at the end. It can be complicated, but let's just say you should have paid $750 on each of the estimated tax dates. Even if you paid $3000 on January 15, 2023, you will still owe penalty interest on each of the $750 amounts you didn't pay on April 15, June 15 and September 15, 2022.

The way to solve your problem is to take money from your tIRA before the end of 2022. In this case $3000. But, instead of you getting the money, you direct the custodian to withhold it all for federal taxes. (I ignore state taxes for the sake of this illustration). Unlike estimated taxes, withholding is considered to occur evenly throughout the year. So you will not face penalty interest for failure to properly pay estimated taxes.

When I was working and saw near the end of the year that I would owe a large tax bill, I would get my payroll department to jack up my wage withholding in November and December to cover it, for exactly the same reason - withholding, even if done in the last month of the year, is considered to have occurred evenly through the year.

Good summary but complicated. What I do every year is I do not calculate estimated income taxes and I do not pay estimated income taxes. In December I pay the safe harbor amount by making a withdrawal from my tIRA at100% withholding. I do this for both the feds and for state income taxes.

Yes, I learned that here.

 

[Gumby]

Good summary but complicated. What I do every year is I do not calculate estimated income taxes and I do not pay estimated income taxes. In December I pay the safe harbor amount by making a withdrawal from my tIRA at100% withholding. I do this for both the feds and for state income taxes.

Yes, I learned that here.

I have thought about just doing that, but one advantage of making estimated payments is that I can do it with after tax dollars. If I am close to the next marginal tax bracket or IRMAA tier, I may not want the additional MAGI by drawing from my tIRA.

 

[COcheesehead]

I have thought about just doing that, but one advantage of making estimated payments is that I can do it with after tax dollars. If I am close to the next marginal tax bracket or IRMAA tier, I may not want the additional MAGI by drawing from my tIRA.

I have to think about the strategy because it does sound odd to pay your taxes while increasing income at the same time.

 

[OldShooter]

I have thought about just doing that, but one advantage of making estimated payments is that I can do it with after tax dollars. If I am close to the next marginal tax bracket or IRMAA tier, I may not want the additional MAGI by drawing from my tIRA.

Yes. That's the trade-off. In our case all of our investment assets are in tIRAs, so no decision necessary.

 

[Graybeard]

I have a question about this paying estimated taxes.

So far in retirement I have federal tax only withheld from my monthly pension and nothing from SS, I don't have enough income to pay state taxes. What I withhold is based upon what I owed the prior year, there's some interest from CDs or bank accounts but not thousands of dollars. I never had an issue doing this since I retired 15 years ago.

This year I have to take RMDs and my income will double. I have taken my entire RMD from my 401k and had some federal and all the state tax I expect to owe withheld, that was done a few weeks ago. I have only taken just less than 25% of my IRA RMD 4-5 months ago and expect to do the rest in about 2 weeks withholding federal taxes based upon what the CPA estimated I would owe this year with my income doubling. Like my pension or SS, I assume withholding taxes when doing the RMDs is the correct time vs quarterly payments. Have I run afoul of some damned IRS rule no one ever told me about and face a penalty for 2022?

 

[NW-Bound]

I have to think about the strategy because it does sound odd to pay your taxes while increasing income at the same time.

I guess you need to leave some head room, in order to do a Dec-30 withdrawal to square things up.

 

[Gumby]

I have a question about this paying estimated taxes.

So far in retirement I have federal tax only withheld from my monthly pension and nothing from SS, I don't have enough income to pay state taxes. What I withhold is based upon what I owed the prior year, there's some interest from CDs or bank accounts but not thousands of dollars. I never had an issue doing this since I retired 15 years ago.

This year I have to take RMDs and my income will double. I have taken my entire RMD from my 401k and had some federal and all the state tax I expect to owe withheld, that was done a few weeks ago. I have only taken just less than 25% of my IRA RMD 4-5 months ago and expect to do the rest in about 2 weeks withholding federal taxes based upon what the CPA estimated I would owe this year with my income doubling. Like my pension or SS, I assume withholding taxes when doing the RMDs is the correct time vs quarterly payments. Have I run afoul of some damned IRS rule no one ever told me about and face a penalty for 2022?

As I mentioned earlier, withholding from an IRA distribution (an RMD in your case) is considered to have been spread over the entire year. So, as long as that withholding plus your monthly pension withholding is sufficient to get you over the safe harbor amount or within $1000 of the taxes due, you should be golden.

 

[OldShooter]

As long as the total you pay is at least the safe harbor amount you are probably good. As your CPA about any timing issues.

 

[Out-to-Lunch]

I have thought about just doing that, but one advantage of making estimated payments is that I can do it with after tax dollars. If I am close to the next marginal tax bracket or IRMAA tier, I may not want the additional MAGI by drawing from my tIRA.

Yes, but there is a way around this, too. As we have discussed before, you can make a check out to your tIRA in the same amount as your withdrawal, and deem the whole transaction to be an indirect rollover to your tIRA.

 

[NW-Bound]

... Like my pension or SS, I assume withholding taxes when doing the RMDs is the correct time vs quarterly payments. Have I run afoul of some damned IRS rule no one ever told me about and face a penalty for 2022?

Yes. The idea is to pay taxes as you receive the income.

Quarterly payments are more meaningful for people who receive income without taxes withheld, such as self-employed people or small businesses.

 

[Gumby]

Yes, but there is a way around this, too. As we have discussed before, you can make a check out to your tIRA in the same amount as your withdrawal, and deem the whole transaction to be an indirect rollover to your tIRA.

I don't have earned income and cannot contribute to a tIRA, only withdraw from it or convert it.

 

[NW-Bound]

As I mentioned earlier, withholding from an IRA distribution (an RMD in your case) is considered to have been spread over the entire year...

I think the spirit of the law is that you pay taxes as you obtain the income.

So, not paying taxes throughout the year, then paying it all at the end of the year would not be kosher.

However, there's no mechanism to track this, so people get away with it.

I happen to know one area in taxes that is not enforced, and I could have gotten away with not paying any taxes, let alone paying late. I could have cheated, but did not.

 

[NW-Bound]

I don't have earned income and cannot contribute to a tIRA, only withdraw from it or convert it.

As Out-to-lunch described, it's a "rollover" or an "IRA transfer" so that you can undo the withdrawal, and not a new contribution.

Now, I wonder if you need to "rollover" to a 2nd IRA, or just putting it back to the original IRA is OK.


PS. I just thought of something. When you withdraw from an IRA, don't you have to specify what type of withdrawal that is? If so, you cannot do a Mulligan, change your mind and say it's now a rollover. Right?

 

[OldShooter]

I think the spirit of the law is that you pay taxes as you obtain the income. So, not paying taxes throughout the year, then paying it all at the end of the year would not be kosher. ...

Judge Learned Hand:

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands."
​

 

[NW-Bound]

Judge Learned Hand:

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands."
​

No, it's not quite the same.

Not paying throughout the year, then paying it all at the end and getting away with it is like not making a full stop at a stop sign.

You get away with it because there are not enough cops to watch every stop sign.

The above quote talks about minimizing taxes while following the law.

 

[Gumby]

No, it's not quite the same.

Not paying throughout the year, then paying it all at the end and getting away with it is like not making a full stop at a stop sign.

You get away with it because there are not enough cops to watch every stop sign.

The IRS already accepts that when you pay them may not match when you received the income. For example, you could make a large tIRA distribution in January and then make 4 equal quarterly estimated tax payments over the next year. So long as they add up to the tax due, it's kosher with the IRS.

https://www.irs.gov/taxtopics/tc306

Generally, taxpayers should make estimated tax payments in four equal amounts to avoid a penalty.

 

[OldShooter]

... Not paying throughout the year, then paying it all at the end and getting away with it is like not making a full stop at a stop sign. ...

Please provide a legal citation for this law or regulation you are so concerned about. NOT a link to some advisory circular.

 

[Out-to-Lunch]

I don't have earned income and cannot contribute to a tIRA, only withdraw from it or convert it.

This is not a contribution, so you don't need earned income. It is a rollover from one tax-deferred account to another.

I actually did this last year, based on what I learned here!

 

[NW-Bound]

Please provide a legal citation for this law or regulation you are so concerned about. NOT a link to some advisory circular.

Please see the IRS topic that Gumby cited above: https://www.irs.gov/taxtopics/tc306.

A lot of people get away with it. I do it too.

I was responding to Graybeard when he wondered if he should do it by quarterly tax payments instead of by withholding. I said that what Graybeard did by tax withholding at the time of withdrawals is exactly right.

About paying in lump sum at year end, we little people can get away with it, but I imagine that a billionaire whose tax liability runs in the tens of million of dollars would not be able to do the same. Nor do corporations.

 

[OldShooter]

Please see the IRS topic that Gumby cited above: https://www.irs.gov/taxtopics/tc306. ...

Irrelevant. I asked for a legal citation.

I imagine that a billionaire whose tax liability runs in the tens of million of dollars would not be able to do the same. Nor do corporations.

Is that your very own fact?

 

[RobbieB]

I have paid penalties for under paying taxes, turbo tax added them to my bill.

Far from billionaire....one can only hope -

 

[NW-Bound]

This is not a contribution, so you don't need earned income. It is a rollover from one tax-deferred account to another.

I actually did this last year, based on what I learned here!

My brokerages have online forms that I fill out when making an IRA withdrawal. When I specify that it is a regular withdrawal (for people above 59-1/2), they will send me a 1099 form stating that the amount is taxable.

This info is also sent to the IRS. How do I notify the IRS of my change of intent regarding this withdrawal? Do I need to?

 

[Gumby]

I have moved all the above posts to this thread to avoid dragging the other thread off track. So this is now the place to talk about the withholding and estimated tax payments to avoid penalties.