Paying Taxes in Retirement With Tax Withholding Distributions

[Out-to-Lunch]

Why aren’t the dollars going into the IRA taxed? My marginal rate is 25%. I had to earn 90/(1-.25)=120 to get the 90 residual which I’ve paid $35 of taxes on. Now the 90 is aftertax until I put it into my IRA and call it a rollover. Plus the extra 10 cost me >13 including the taxes. Eventually that $100 payment back to the IRA will be taxed again.

Let me try a slightly different way:

Let's say that you have a $1000 tax liability you need to pay. You have $1000 in a tIRA. And you have $1000 in a taxable bank account.

Scenario 1: You pay your taxes from your bank account. Now you have no tax liability; you have $1000 in your tIRA, and you have nothing in your bank account. And you owe a penalty for underpayment.

Scenario 2: You make a withdrawal of $1000 from your tIRA, and have it all withheld for taxes. Later, you take your $1000 from your bank account, write a check to your tIRA as an indirect rollover. After that, you have no tax liability; you have $1000 in your tIRA, and you have nothing in your bank account. Just as before. But you do NOT owe a penalty for underpayment.


What you seem to be missing is that when you put the (previously taxed) money into the tIRA, you are PREVENTING the taxation of the money that was taken out before. So, I guess you could insist on saying that your previously taxed money is being taxed again, but you are ignoring the fact that it prevents you from paying taxes on the money that you withdrew earlier (which had never been taxed before).

 

[jazz4cash]

What you seem to be missing is that when you put the (previously taxed) money into the tIRA, you are PREVENTING the taxation of the money that was taken out before. So, I guess you could insist on saying that your previously taxed money is being taxed again, but you are ignoring the fact that it prevents you from paying taxes on the money that you withdrew earlier (which had never been taxed before).

I dont think I’m missing anything. You stated that previously taxed money is going into the IRA so you must agree it will be taxed again when distributed. Perhaps the cost of double taxation is less than the underpayment penalty. I have no idea.

 

[RetireBy90]

We have been doing this for years with no penalties except (true confessions time) last year when I paid 100% of the prior years taxes, forgetting that at our AGI we are required to pay 110%.

Started this a couple years ago after reading a thread and I believe a post by OldShooter. I’m not sure it is the most efficient way to pay my taxes but it is much easier for me. I tried quarterly payments but changes to income, mostly from tIRA draws for one off spending made my Jan plans go to he11.
I just yesterday did the year end draw and if my model is correct I’ll owe $500 to feds and get $250 back from state.
Thanks to OldShooter for telling me (us) about this.

 

[G-Man]

Started this a couple years ago after reading a thread and I believe a post by OldShooter. I’m not sure it is the most efficient way to pay my taxes but it is much easier for me. I tried quarterly payments but changes to income, mostly from tIRA draws for one off spending made my Jan plans go to he11.
I just yesterday did the year end draw and if my model is correct I’ll owe $500 to feds and get $250 back from state.
Thanks to OldShooter for telling me (us) about this.

Can you provide a link to the original thread. As I approach retirement, I find these threads very useful.

 

[Scarab]

Can you provide a link to the original thread. As I approach retirement, I find these threads very useful.

At the risk of giving away my age range, "ditto" here on your comment. My head is spinning reading this particular thread. I'm 'gonna need animal pictures.

 

[Exchme]

I dont think I’m missing anything. You stated that previously taxed money is going into the IRA so you must agree it will be taxed again when distributed. Perhaps the cost of double taxation is less than the underpayment penalty. I have no idea.

out-to-lunch explained it clearly. There is no double taxation. The 60 day rollover rule allows you to cancel the first taxation of the IRA distribution as you put the money back into the IRA. So the taxable balance, IRA balance and your taxes end up exactly as they would be if you had paid the taxes from taxable.

The only difference is the IRS is happy now as they received taxes via withholding (which are deemed timely, so no penalties). Had you just paid out of taxable directly, the tax payment is counted towards the 4Q taxes (or whenever you paid them), so you may have a penalty.

 

[RetireBy90]

Can you provide a link to the original thread. As I approach retirement, I find these threads very useful.

There are several, but I found his comments here, post #16

https://www.early-retirement.org/forums/f28/i-missed-june-estimated-tax-payment-118269.html

Hopefully OldShooter will respond

 

[PointBreeze]

The strategy seems very common with the members here. I also "pay my taxes" in December when I pull from a not-yet-taxed retirement account.

This is the time of year I do my taxes. Doing them today. I have an "inputs sheet" that I maintain, and things don't change too much year to year, so typing the values (and of course some estimates) takes just a few minutes. Then it takes a while to iterate on tIRA withdrawals and/or Roth conversions to land where I want in the marginal tax rate spectrum. Since I'm using the full tax return calculation, it includes everything, including ACA PTC.

But at the end, I know what I'll need to withhold for both federal and state. The tax software guides me through filling out the form so I don't get a penalty.

Sengsational, how do you calculate the ACA PTC? I can’t find the premium for out the 2nd lowest cost Silver plan in my area, which is key to the calculation, I believe.

 

[DJRR]

out-to-lunch explained it clearly. There is no double taxation. The 60 day rollover rule allows you to cancel the first taxation of the IRA distribution as you put the money back into the IRA. So the taxable balance, IRA balance and your taxes end up exactly as they would be if you had paid the taxes from taxable.

The only difference is the IRS is happy now as they received taxes via withholding (which are deemed timely, so no penalties). Had you just paid out of taxable directly, the tax payment is counted towards the 4Q taxes (or whenever you paid them), so you may have a penalty.

Does that work across tax years? You take the distribution in 2023, triggering a 2023 tax, but withhold 100%. You pay it back in January 2024. Does this eliminate the 2023 tax liability for the withdrawal as long as you have not filed your taxes yet?

 

[pb4uski]

Does that work across tax years? You take the distribution in 2023, triggering a 2023 tax, but withhold 100%. You pay it back in January 2024. Does this eliminate the 2023 tax liability for the withdrawal as long as you have not filed your taxes yet?

Yes. You would get a 1099-R for the 2023 tIRA withdrawal that would be income but you would also report it as a rollover contribution. As long as it is within the 60-day window and you otherwise qualify (only one rollover every 12 months or something like that) then it doesn't matter if it crossed tax years.

... Indirect rollovers are entered into TurboTax by entering the Form 1099-R that reports the distribution from the original retirement account and in the follow-up indicating that the money was moved to another retirement account (or returned to the same account), then indicating how much of the distribution was rolled over. The gross amounts of all Forms 1099-R will be included on 2019 Form 1040 line 4a but amounts reported as rolled over will be excluded from the taxable amount on line 4b. Only the amount on line 4b adds to your taxable income.

 

[OldShooter]

... Hopefully OldShooter will respond

Not sure what I'm supposed to respond to. I really don't deserve credit on this withholding idea, though. I learned about it here on he forums just like many others.

One thing still puzzles me though: All this angst about estimating taxes due/the amount to be withheld. Why? Unless someone's income is varying significantly from year to year, it is trivially easy to have the safe harbor amount withheld, then sort out any over- or under-payment when the tax return is filed. No penalties ever. (Lots of references; here is one: https://www.hrblock.com/tax-center/irs/tax-responsibilities/avoiding-underpayment-tax-penalty/)

 

[RetireBy90]

Not sure what I'm supposed to respond to. I really don't deserve credit on this withholding idea, though. I learned about it here on he forums just like many others.

I remember a post you made, not sure if it is the one I quoted or not, but it was after that I figured how much I owed after various other withholding on SS and small pensions and did the tIRA draw.

One thing still puzzles me though: All this angst about estimating taxes due/the amount to be withheld. Why? Unless someone's income is varying significantly from year to year, it is trivially easy to have the safe harbor amount withheld, then sort out any over- or under-payment when the tax return is filed. No penalties ever. (Lots of references; here is one: https://www.hrblock.com/tax-center/irs/tax-responsibilities/avoiding-underpayment-tax-penalty/)

I for one, in 2022 made way too much in Roth conversions so 110% of 2022 tax would be about double my 2023 tax owed so no 110% for me. Went from normal paycheck in 2018 to DW SS in 2019, doing Roth Conversions 2020 to today, and in 2 years I'll start SS. Hope to get to the point where I can make a good estimate early in the year.

 

[Montecfo]

I dont think I’m missing anything. You stated that previously taxed money is going into the IRA so you must agree it will be taxed again when distributed. Perhaps the cost of double taxation is less than the underpayment penalty. I have no idea.

Jazz4cash,
.
The money pulled from the IRA (untaxed funds) is being returned to the IRA (still untaxed). This prevents those funds from being subject to tax at this time.
.
They are not being subjected to tax at all as a result of this withdrawal and payback tactic.

You are simply using the withdrawal as a tool to make your tax payment. Like any good tool it should be replaced when done.

 

[Dtail]

Not sure if this was asked yet.
For RMD withholding, can one overwithhold from the RMD and then in a separate transaction later on in the year make a Roth conversion and effectively use the overwithholding to pay the taxes on the Roth conversion?

 

[CardsFan]

One thing still puzzles me though: All this angst about estimating taxes due/the amount to be withheld. Why? Unless someone's income is varying significantly from year to year, it is trivially easy to have the safe harbor amount withheld, then sort out any over- or under-payment when the tax return is filed. No penalties ever. (Lots of references; here is one: https://www.hrblock.com/tax-center/irs/tax-responsibilities/avoiding-underpayment-tax-penalty/)

Yep to the bold above.

We don't have any withholding, just pay quarterlies. Figure it out when I do the taxes, schedule it, and done for the year. I do need to file state quarterly, but the EFTPS systems for the feds sends me a notice just before they take the money, and that is the reminder to pay the state.

Why make it more complicated than it needs to be?

 

[lucky penny]

Yep to the bold above.

We don't have any withholding, just pay quarterlies. Figure it out when I do the taxes, schedule it, and done for the year. I do need to file state quarterly, but the EFTPS systems for the feds sends me a notice just before they take the money, and that is the reminder to pay the state.

Why make it more complicated than it needs to be?

An advantage of using large RMD withholding payments at the end of the year, rather than making estimated tax payments throughout the year, is that the money stays in your accounts a lot longer earning income for you.

 

[jaga]

Can the safe harbor method be used even for those with a small business? (single person LLC, reported on Schd C).
I’ve been hesitant to try it.

 

[DrRoy]

The scheme does not reduce your taxes. It just rearranges when you pay them.

That is what it seemed like to me.

 

[audreyh1]

The scheme does not reduce your taxes. It just rearranges when you pay them.

That is what it seemed like to me.

It can be used to avoid an underpayment tax penalty which I think is the whole point of the exercise.

 

[lem1955]

No. The funds are not taxable if returned to a qualified plan within 60 days. This is the so called "60 Day Rule". It is simply a method to fund a tax payment through withholding, which is treated more favorably, instead of an estimated tax payment.

I understand the replenishment isn't taxable immediately, but down the road isn't it simply in the traditional IRA and therefore taxable when I withdraw two years later?

 

[rayvt]

One thing still puzzles me though: All this angst about estimating taxes due/the amount to be withheld. Why? Unless someone's income is varying significantly from year to year...

You pay your tax as late as possible, without getting hit with underwithholding penalty. Leave your money invested in stocks/CDs for the entire year.

You don't need to mess around with quarterly payments.

You don't have to fill out that stupid form explaining why the 4th quarterly payment was much higher than the others. (Due to getting unpredictable capital gains in December from your mutual funds.)

IF you do the 60-day rollover trick, you take some or all of your RMD in January. You cannot do Roth conversions until you've taken your entire RMD. (If you are one of those who like to do Roth conversions.)

In December you have a pretty good idea of what your tax will be. You can therfore tailor your withholding amount to be just under that so that you'll have to write only a small check instead of getting a refund. Financially savvy people abhor tax refunds.

Seeing as this is the RE & FI community there is a real possibility of getting capital gains in December that we could not anticipate.

 

[pb4uski]

Can the safe harbor method be used even for those with a small business? (single person LLC, reported on Schd C).
I’ve been hesitant to try it.

Yes, because at the end of the day your single person LLC results in an individual income tax obligation and the safe harbor relates to your total individual income tax obligation.

 

[rayvt]

I understand the replenishment isn't taxable immediately, but down the road isn't it simply in the traditional IRA and therefore taxable when I withdraw two years later?

Yes. But it doesn't matter. If you do a 60-day rollover it's treated as if you never made the withdrawal at all.

[edit:] This is really a trick to pay the 2023 tax with a withdrawal made in 2024.

[edit 2] You could do the 60-day rollover with money from a savings account. Works the same. You could then replenish the savings account by an IRA withdrawal in the next January--or any time in the next year.

 

[lem1955]

Yes. But it doesn't matter. If you do a 60-day rollover it's treated as if you never made the withdrawal at all.

Got it! Thanks.

 

[rayvt]

Not sure if this was asked yet.
For RMD withholding, can one overwithhold from the RMD and then in a separate transaction later on in the year make a Roth conversion and effectively use the overwithholding to pay the taxes on the Roth conversion?

Not quite sure what you are asking.

There is no "RMD withholding".
There is IRA withdrawals.
There is amount withheld from the withdrawal.
Separately, there is the minimum amount you are required to withdraw.

Do you mean if you withdraw more than your RMD? Or more than the safe harbor tax?

Money is fungible, so it does not matter where the money came from to pay the tax due to Roth conversions.

You cannot do Roth conversions until you have taken your RMD.
(Well actually you can, since the 1099 and 5498 forms don't have the dates of the individual transactions, just the sums for the entire year. But if the IRS dig into your details they will find out and can hit you with nasty penalties.)