After retiring, your taxable income may consist entirely of IRA distributions and investment returns. You’ll have two ways to remit the tax owed on this income to the IRS: (1) make quarterly estimated tax payments, (2) have tax withheld from the distributions.
Which is the best to use? Here’s what you need to know when making your choice.
If you choose this method the IRS will want to receive the tax you owe for the year in four equal payments due on April 15, June 15, September 15, and January 15 of the following year.
Or you can pay tax for each period as income is received. This is best if most income will be received later in the year, as it allows smaller payments to be made early in the year and larger ones later.
A challenge with using quarterly payments is that you must accurately estimate from the start of the year your full income for the entire year. If you overestimate that income your first quarterly payments will be too large and you’ll make a loan to the IRS. If you underestimate, your first payments will be too small and you may incur a penalty.
You must also take the effort to manage your own payments to the IRS, making them either by voucher or electronically. And, by mistake or otherwise, people often fail to make early quarterly payments altogether, incurring even larger late-payment penalties when they finally do remit what they owe.
When you receive a taxable distribution from an IRA you have the option to have tax withheld from it by the IRA custodian to be remitted directly to the IRS. In fact, by default the custodian will withhold 10% of the distribution. However, you can instruct the custodian to withhold either 0% or more than 10%, up to as much as 100%.
Using withholding saves the trouble of sending a payment to the IRS yourself. It also has another big advantage: Withheld tax is treated as if it is paid at an even rate over the year even if in fact it is all paid just before year-end.
This means that withholding on an IRA distribution taken just before year-end can be used to retroactively escape underpayment penalties on earlier missed quarterly estimated payments.
Example: Say your taxable income for the year will come entirely from a mix of investment income and IRA distributions, and that you have accurately estimated your tax bracket rate for the year. You can pay the tax you owe on the investment income by applying that tax bracket rate to it as it is received and remitting the resulting tax to the IRS through quarterly payments. Or, alternatively, you can pay no tax on the investment income as it is received, make no quarterly payments, and increase the amount withheld from your final IRA distribution of the year to cover the tax due on the investment income retroactively. The result is that you save cash flow by deferring paying the tax on your investment income until near year end, without incurring any late-payment penalty.
Roth IRA conversions
When a traditional IRA is converted to a Roth IRA the converted amount is a taxable distribution subject to the same withholding rules described above. If no withholding election is made, by default, the custodian will withhold 10% tax from the converted amount.
But while use of withholding may appear attractive in the earlier scenario, it is not so here. Withholding does not work well with Roth IRA conversions.
When tax is withheld from a Roth IRA conversion, the amount withheld is a taxable distribution itself, additional to the amount being converted. So one must take yet more from the IRA or somewhere else to pay the tax due on the amount distributed to pay the tax. If one is under age 59 1/2, an early withdrawal penalty applies too, so it is even worse. And, of course, the amount withheld depletes the IRA and reduces the future tax benefits from it accordingly.
Thus, withholding is not recommended for a Roth IRA conversion. It is generally much better to pay the tax due on a Roth conversion using non-IRA funds through quarterly estimated payments (or perhaps wage withholding), while instructing the IRA custodian to withhold 0% rather than the default rate. This minimizes the current tax bill and keeps the IRA intact to preserve all its future tax benefits.
Know the rules
Quarterly payments and withholding can be used together. Of course, if tax is underpaid during the year penalties will apply no matter what payment method is used.
The exact rules regarding required payment amounts and underpayment penalties vary by situation. For all the details that may apply to you, see IRS Publication 505, Tax Withholding and Estimated Tax, available online at IRS.gov.