The United States tax system is set up on a “pay-as-you-go” basis, which means that taxpayers are required to pay taxes throughout the year as income is earned, whether it be through withholding income or making estimated tax payments. Individuals who don’t pay timely taxes throughout the year may be assessed Estimated Tax Penalties by the IRS, which are based on the amount of unpaid tax and the Federal short-term rate (in the first month of the quarter in which taxes were not paid) plus three percent. While understanding and helping clients comply with the requirements of tax payments can preclude Estimated Tax Penalties, advisors can also use simple arbitrage strategies to help clients maximize their savings when making estimated tax payments with tax-advantaged retirement account distributions.
While taxpayers who have income withheld to pay their tax liability generally aren’t required to make quarterly payments (as the IRS considers withholdings as if they were paid throughout the year, regardless of when they were actually paid), those who opt to make estimated tax payments must pay their estimated tax liability on a quarterly basis following a schedule of “General Due Dates for Estimated Tax Installment Payments” provided by the IRS. For taxpayers who choose to pay their taxes with estimated tax payments (versus through withholding taxes from paychecks or other qualifying accounts such as pensions or retirement plans), there are basically three options to calculate tax payments. Tax payments can be estimated based on the taxpayer’s prior year’s tax liability, where the estimated annual amount is equal to 100% of the prior year’s tax for income under $150,000, or 110% for income over $150,000, with the total estimated amount paid in equal quarterly installments. While this is generally the simpler way to calculate estimated payments (and more fool-proof in avoiding penalties, since the prior year’s tax will generally be known), individuals can also make estimated tax payments based on the current year’s tax liability instead. In this case, the amount due would be 90% of the current year’s liability paid in equal quarterly installments. The caveat to using the current year’s tax liability to calculate estimated tax payments is that, if the tax liability is underestimated, tax payments may be too low, and an Estimated Tax Penalty may result. The third way to make estimated tax payments is to use the Annualized Income Installment method, in which payments are based on the individual’s actual quarterly tax liability. While this method is cumbersome and time-consuming, it can be beneficial for taxpayers who earn income unevenly throughout the year.
Clients who pay their taxes by withholding income can benefit from the fact that quarterly payments are not necessarily required by the IRS. While paychecks are generally received on a regular basis throughout the year, resulting in withholding taxes in a true “pay-as-you-go” manner as intended by the IRS, retirement account distributions are often made only once per year, which effectively creates a “pay-as-you-go” loophole for taxpayers whose income consists of retirement account distributions! Because of this, advisors whose clients rely on retirement account distributions for income can help maximize savings by withholding taxes later in the year, thereby letting clients keep their money longer (and letting those funds grow in the meantime) without risk of incurring Estimated Tax Penalties.
For clients who may have inadvertently underpaid (or missed) estimated tax payments during the year, using an ‘erase-and-replace’ strategy can help them avoid an Estimated Tax Penalty by using a retirement account to withdraw the amount of underpaid estimated tax and withholding the entire amount from that distribution. The client can then ‘roll over’ non-retirement funds (that otherwise would have been used to make the estimated tax payment) within 60 days of the distribution to avoid any taxes due on the distribution itself, provided that no other rollovers have been made in the last year (so as not to violate the once-per-year-IRA-rollover ule).
Ultimately, the key point is that by leveraging the flexibility of tax withholding from retirement account distributions, advisors can develop strategies to help clients avoid tax penalties while keeping their money invested for longer and postponing tax withholdings until later in the year.