Roth IRA Conversions and Estimated Tax Payments
We are currently making estimated tax payments every quarter, paying equal amounts totaling the prior year’s tax. Our reason for doing this is so that we can do at least one Roth IRA conversion every year. Our only other income is my pension and soon, regular monthly payments from a Traditional IRA. My question is, if I started having tax withheld from my pension every month, enough to cover the tax I would owe on the pension and IRA payments, and later in the year do a Roth conversion, can I make an estimated payment that would cover the tax for that conversion at that time, and avoid having to file Form 2210? I’m trying to figure what our options are if we wanted to avoid making quarterly payments, and weighing that against making tax filing simpler (and avoid filing Form 2210). I’ve read Publication 505 and am still unclear about having to file Form 2210. Also, instead of going by the prior year’s tax, is it possible to make unequal estimated taxes every quarter if those amounts equaled the amount of tax we would owe for that quarter, assuming we were doing Roth conversions, and again avoid filing Form 2210? I hope my questions are clear enough. Thank you for any help.
Permalink Submitted by Alan - IRA critic on Tue, 2018-03-13 00:20
You can combine withholding and quarterlies, but doing so correctly adds complexity. Equal quarterly estimates for the amount remaining after any withholding must meet one of the safe harbors (100% of last year’s tax liability, 110% for higher incomes, or 90% of the current year tax liability. If you instead want to pay as you go because you are converting toward year end, you will have to use the 2210 annualized income installment method to split your income and deductions into the proper quarterly time period. This is the form most people want to avoid. If your IRA RMD is large enough to have your entire safe harbor withholding done from the RMD, you will not need to pay quarterlies, and if you take your RMD late in the year, that is OK because withholding is deemed to have been paid equally throughout the year even though you paid at the end. You could also use your pension for withholding if it is large enough, but that source would be paid monthly, but if your pension allows you to make one change a year, you could backload your pension withholding as well, for example have the amount you need taken from just the last 3 months payments. Remember, if you meet any of the safe harbors using the prior year taxes, you will never pay a penalty even though you may have a large tax bill in April.
Permalink Submitted by Peter Karakondis on Tue, 2018-03-13 18:37
I guess continuing to make the equal quarterly payments might be the best way to keep tax filing simple. But I’m not sure I understand two of your comments: “If your IRA RMD is large enough to have your entire safe harbor withholding done from the RMD, you will not need to pay quarterlies, and if you take your RMD late in the year, that is OK because withholding is deemed to have been paid equally throughout the year even though you paid at the end.” We will begin taking monthly payments from my Traditional IRA for living expenses, not as RMD’s (I’m 62), and I don’t want to have taxes withheld from those payments, but maybe it doesn’t make sense to do that? Does it make sense to pay our taxes out of our taxable savings and pension instead? And if we do our Roth conversion at the end of the year, I think you’re saying that making a large quarterly payment at that time will not be good enough to avoid the 2210? Also “You could also use your pension for withholding if it is large enough, but that source would be paid monthly, but if your pension allows you to make one change a year, you could backload your pension withholding as well, for example have the amount you need taken from just the last 3 months payments.” I never thought of that; are you saying that if I have enough tax withheld from my pension every month to cover the pension and IRA payments, and we do a Roth conversion in the last quarter, I can just increase my withholding amount for those last three pension payments so that it would also cover the cost of the tax for the conversion (and allow us to avoid the quarterly payments and the 2210)? If I understand that correctly, I don’t understand why it would matter to the IRS if the tax for that quarter is paid by withholding as opposed to an estimated tax payment if both amounts would be the same (why do they need the 2210?). I guess there must be a reason for that, but maybe not. Again, I want to thank you for all your help; I’m exhaused just from trying to phrase my questions, but spending hours on the phone with the IRS is an undesirable option that I want to avoid. Thank You.
Permalink Submitted by Alan - IRA critic on Tue, 2018-03-13 22:21
Your best solution depends on the amount of distributions you will take, and whether you care about back loading your payments or not. You should be able to avoid the 2210 easily enough. All your distributions except the conversion are monthly, so back loading your withholding is more difficult depending on how easy it is to contact your pension twice a year to change your withholding % and get it processed quickly. As for the IRS rule, since withholding historically has mostly been paid on salaries, the IRS has always treated it as being paid equally throughout the year even when it isn’t. Applying this to pensions and retirement accounts presents sort of a loophole and alot of people taking RMDs take their RMD in December and have enough withholding taken from that RMD to meet their objective, which is typically to equal 100% of their prior year tax liability. In your case, pension withholding will help you avoid quarterly estimates which are only deemed paid when received, not equally throughout the year as for withholding. If you are taking IRA distribution without withholding, but paying quarterly estimates from your other money, your net cash flow will hardly differ if you change to withholding from the IRA and pension distributions and eliminate the quarterly payments. If you convert to Roth however, you will have to increase the withholding enough to meet 100% of your prior year tax liability, so you do not need to know the amount you are going to convert when planning your withholding plan.
Permalink Submitted by Peter Karakondis on Wed, 2018-03-14 17:13
To keep things simple, it seems we should just keep making the equal estimated tax payments that total our prior year tax liability and not be obligated to do any withholding or file the 2210. Thanks again.
Permalink Submitted by Alan - IRA critic on Wed, 2018-03-14 17:24
That is certainly a valid choice. However, if you do a large conversion and the following year you don’t or your taxable income drops due to any reason, then you may want to switch your estimates to a safe harbor of 90% of your current year taxes. While that would prevent you from fronting alot of money and getting a large refund due to a major drop in income, determining your current year taxes up front is a challenge compared to using the prior year figure which you will clearly know by the time the first estimate is due 4/15.
Permalink Submitted by Peter Karakondis on Wed, 2018-03-14 18:39
That was my next question. So once we finish our conversions in four or five years, we can then pay 90% of that year’s taxes with equal estimated quarterly payments (or begin withholding enough tax from my pension every month to cover that amount)? If my pension and our monthly IRA payment amounts never change, it should be easy to figure the amount, but if there is an unexpected change during the year, would changing the withholding amount at that time be good enough to avoid the 2210? Our taxes for the conversion years may be around $10,000, and after that, around $2,000, so it would be nice to not pay that larger amount upfront. Also, I understand why it makes sense to pay for the conversions without taking it from the converted amount, but as far as taxes on Traditional IRA distributions, does it make a difference if it is paid from a taxable account or if it is withheld from that IRA payment? I’m still confused about that. Thanks for you help.
Permalink Submitted by Alan - IRA critic on Wed, 2018-03-14 19:54
As long as your taxable income does not vary by too much, the prior year tax liability safe harbor works well. And for the year it rises significantly, it will still avoid any penalty but there will be large tax due amount in April. But when your taxable income drops and to avoid excessive estimates, your safe harbor will become 90% of your current year tax liability since that will be less. You can still use estimates of 25% of the 90% or you can use withholding if you want. While a hassle, you can switch from and to withholding at anytime, and can even mix the two in any given year. For example, when your income drops you might find after 3 quarterlies that you will fall short of the 90%, and paying a large estimate in January will not eliminate a possible penalty for the first 3 quarters. However, if you had a large enough withholding done from a late year distribution, that withholding would shore up your early estimate amounts because it is deemed to apply equally throughout the year. Therefore, withholding can be introduced anytime to avoid a 2210 or penalty. As for IRA withholding, it works very well for RMDs and ordinary distributions, however for a conversion or non conversion rollover, it forces you to use other money to complete the rollover or conversion. For example, if you convert 50k with 20% withholding, only 40k goes to the Roth and 10k to the IRS and is lost from your retirement accounts. To eliminate that loss you still have 60 days to roll 10k of your other money into your Roth and now you have converted all 50k. In a pinch you could do that and it would get 10k of withholding to the IRS immediately, but you have to know what you are doing.
Permalink Submitted by Peter Karakondis on Thu, 2018-03-15 01:01
Thanks for all the information!
Permalink Submitted by Peter Karakondis on Thu, 2018-03-15 14:26
I’m still unclear about one thing. If we have tax withheld from my pension and TIRA payments, and then do a Roth conversion at the end of the year and an estimated tax payment to cover that amount at that time, do we still have to file the 2210?
Permalink Submitted by Alan - IRA critic on Thu, 2018-03-15 15:31
If you have enough withheld from your pension and TIRA distributions to meet a safe harbor (either 100% prior year tax liability or 90% of current year) it does not matter how much you owe because of the conversion as there will be no penalty. I think you are referring to the situation where your income dropped and your withholding is based on 90% of what you think your current taxes will be – then you decide to convert a large amount late in the year and wished you had used the 100% of prior year taxes to determine your withholding. Then you have a choice to either increase your withholding to a large enough amount for the time remaining in the year or pay a quarterly estimate in January. if you do the latter you will need the 2210 to show that your conversion income and the single estimate were both in the same period. Of course, the penalty is not really severe since interest rates are still low, but since withholding is so flexible you can usually manage it easily enough to avoid estimates.
Permalink Submitted by Peter Karakondis on Thu, 2018-03-15 15:57
So making that quarterly payment in January would require us to file the 2210, but increasing withholding to a large enough amount for the time remaining in the year would not?
Permalink Submitted by Alan - IRA critic on Thu, 2018-03-15 16:29
Correct, because withholding is credited retroactively throughout the year. An extra 6000 in December withholding is treated as being received 1500 per quarter, so it makes up shortfalls in earlier quarters. A quarterly payment is only credited when paid, so would only help with respect to the final quarter. For the first 3 quarters, the 2210 would be needed to show that a shortfall in the first quarters was justified because most of the income was generated in the final quarter. Without the 2210 late interest for the first 3 quarters can be billed.
Permalink Submitted by Peter Karakondis on Thu, 2018-03-15 16:42
I finally got it! Thanks so much for explaining that.