IRA withdrawal vs. estimated payments

[Cobra9777]

On July 15, we owe estimated tax payments for 1Q and 2Q. We have no withholding of any kind. It will be a complicated tax year due to selling a rental in 3Q. Depending on that impact, we may or may not make our usual Roth conversion in 4Q. So, plenty of unknowns as I contemplate how much money to send the IRS in a few days.

In similar situations in the past, I've used the annualized income method to avoid penalties for underwithholding. It's a bit of work, but not too bad. So my first instinct was to send minimal payments for 1Q and 2Q. Then larger payments, as required, in 3Q and 4Q. And clean up the mess with Form 2210 when I file.

But then I remembered that some members here pay tax in December by making an IRA withdrawal with 100% withholding. The IRS considers such withholding to have been made equally throughout the year. DW and I both turn 59.5 this year. So this is the first year we could use this method, which seems very straightforward by comparison. But...

I would have to reduce our Roth conversion by the amount of the IRA withdrawal. Although I suppose that has the same effect in terms of reducing future RMDs. I just don't want to commit to any additional taxable income until I see the impact from the rental sale.

Also, we'd be using the IRA instead of taxable funds to pay conversion tax, which drives 80% of our tax liability. This would negate one of the benefits of Roth conversions. OTOH, it would preserve the taxable account for step-up in basis when one of us goes. That may be a larger benefit, though not much fun to think about.

Just curious, for those who do this, are there other pros and cons that I'm not thinking about?

 

[pb4uski]

Another option would be to do an IRA withdrawal with 100% withholding for the safe harbor amount and then do an estimated payment for the rest.

To me the more important thing is to drain down the tIRA before RMDs start and while I have a slight preference to have the money go into the Roth, if it ends up being used to pay taxes then that is fine.

 

[OldShooter]

... do an IRA withdrawal with 100% withholding for the safe harbor amount and then do an estimated payment for the rest. ...

This is exactly what we do and it works fine. Second week of December, 100% withholding, cover the safe harbor amount. Done. Estimating is never needed.

I don't know what @pb4 means about "the rest." AFIK if you do the safe harbor amount there is no "rest."

 

[pb4uski]

I was thinking the extra tax from selling the rental and any 4Q Roth conversions could just be paid as a regular estimated payment in January, with the tIRA withholding to cover what would have been the 1, 2 and 3Q estimated payments.

 

[CardsFan]

I was thinking the extra tax from selling the rental and any 4Q Roth conversions could just be paid as a regular estimated payment in January, with the tIRA withholding to cover what would have been the 1, 2 and 3Q estimated payments.

But, if you met the safe harbor, couldn't you wait until April 15? No need for the 4th Q payment?

 

[Cobra9777]

My thinking was this: Make no estimated payments. In late Dec, figure out the final tax liability including rental sale and conversion(if any). Make an IRA withdrawal (with 100% withholding) equal to 90% of that figure, which satisfies the safe harbor rule. Pay the balance when I file the return.

Pb4's suggestion sort-of splits the amount of tax coming from IRA vs taxable funds. In the OP, I expressed some concern about using IRA funds to pay conversion tax. But with his suggestion, I'd still have to file Form 2210 to show that all the income came in 4Q, which is a minor trade-off.

 

[Cobra9777]

...To me the more important thing is to drain down the tIRA before RMDs start and while I have a slight preference to have the money go into the Roth, if it ends up being used to pay taxes then that is fine.

Agreed. In addition, we are now converting to the top of the 22% bracket, which drives fairly large conversion tax. If I only used taxable funds, we would exhaust that account around age 65-66. So we'd end up using Roth or tIRA money at some point anyway, not just for taxes but to replace the taxable dividends that will slowly go away.

Plus, I'm starting to think that stepped-up basis for the surviving spouse is more valuable than the relatively small benefit of using taxable funds for conversion tax. So I'm warming up to the idea of using IRA funds for taxes. And I really like how this method eliminates quarterly estimates and the need to use Form 2210 for years with uneven income patterns.

Just want to make sure there are no other "gotchas" I haven't thought about before I skip my estimated payments next week.

 

[jollystomper]

We are also using IRA withdrawals in lieu of estimated tax payments. The only difference is that we do not wait until the end of the year. We spread it out during the year, when our IRA is at a perceived "peak", or if we need to re-balance (sell the "winners" and use the proceeds for taxes). I hope to minimize having to take money out of it during extended "down" times.

 

[OldShooter]

I was thinking the extra tax from selling the rental and any 4Q Roth conversions could just be paid as a regular estimated payment in January, with the tIRA withholding to cover what would have been the 1, 2 and 3Q estimated payments.

Well, I guess the question becomes whether the OP's total taxes due will be substantially less than the safe harbor amount.

Assuming that is not the case, then IMO there is no reason to pay in January what is not required until April 15. Just pay the safe harbor amount and get on with life.

If the taxes due are less than the safe harbor amount, then a diligent and dedicated soul like @pb4 would figure the estimated tax payments in detail while a lazy old fart like me would still just pay the safe harbor amount.

 

[Animorph]

A basis step-up in the taxable account is no more valuable than having that money in a Roth account. Either would come to the inheritor with no taxes due. In that sense the two types of accounts are very similar if you can avoid the tax drag of dividends and distributions in addition to no sales.

If you only have really big unrealized capital gains in taxable accounts now, you would be saving that tax by paying taxes with tIRA withdrawals. Might be worth it. If you have enough to cover the tax with minimal capital gains hit that's what I would do.

But my goal is to withdraw from the tIRA at the lowest average tax rate throughout retirement. Reducing RMD's is part of that, but not all. If the taxes due on the extra tIRA withdrawal are in a higher tax bracket than the Roth conversions are targeting then I wouldn't do it.

What taxes are paid with tIRA withdrawal? What taxes are paid with taxable withdrawal? What taxes are saved by reducing the taxable account instead of the Roth account (from now until the first Roth withdrawal)? A bunch of numbers we don't know.

 

[Cobra9777]

A basis step-up in the taxable account is no more valuable than having that money in a Roth account. Either would come to the inheritor with no taxes due. In that sense the two types of accounts are very similar if you can avoid the tax drag of dividends and distributions in addition to no sales.

If you only have really big unrealized capital gains in taxable accounts now, you would be saving that tax by paying taxes with tIRA withdrawals. Might be worth it. If you have enough to cover the tax with minimal capital gains hit that's what I would do.

But my goal is to withdraw from the tIRA at the lowest average tax rate throughout retirement. Reducing RMD's is part of that, but not all. If the taxes due on the extra tIRA withdrawal are in a higher tax bracket than the Roth conversions are targeting then I wouldn't do it.

What taxes are paid with tIRA withdrawal? What taxes are paid with taxable withdrawal? What taxes are saved by reducing the taxable account instead of the Roth account (from now until the first Roth withdrawal)? A bunch of numbers we don't know.

Thanks.

The tIRA withdrawal would not be in a higher bracket than the Roth conversion. We would simply adjust the conversion amount so taxable income was still at the top of the 22% bracket. The effect on current taxes and future RMDs is the same.

It's ingrained in my thinking to use taxable funds to pay conversion tax in order to maximize the Roth. In effect, the taxable funds are "transferred" to the Roth, where they escape taxation forever.

In the past, I've always been able to extract cash tax-efficiently for that purpose. So this has worked out well. And I could probably sustain this for some time based on the current composition of the taxable account.

But at some point, it will get tough. I start thinking about the value of having all those embedded gains go to zero (at some point) versus the then-comparatively small benefit of continuing to "transfer" taxable funds to the Roth. At the point of inheritance, yes, both are tax-free, although the Roth remains so permanently.

In any case... it seems true that the benefit of what I'm proposing in this thread is mainly administrative. In a year of many unknowns and drastically uneven income patterns, I'd like to avoid the messiness of estimated taxes and the annualized income method.

But that means shifting to the IRA instead of taxable funds to cover our conversion tax liability... at a point where I can still tax-efficiently extract cash from taxable. So perhaps administrative expediency is not a good reason to make this shift.