IRA Trick – Eliminate Estimated Tax Payments

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Retirees: don’t you get tired of making those estimated tax payments? January, April, June and September, like clockwork, you have to hand over tax money, just because you’re receiving a pension, retirement funds, and/or Social Security benefits. What if there was a way to send this money off one time, and then you wouldn’t have to remember it every few months?

There is.

IRA Trick – Eliminating Estimated Tax Payments

When you receive money throughout the year, the IRS expects withholding payments or estimated payments to coincide with your receipt of the money. So when you receive a monthly pension check, you should either have some tax withheld out of each payment. On the other hand, you could send in an estimated tax payment, at four intervals throughout the year, which is treated equivalent to check-deducted withholding.

These estimated payments, often wrongly referred to as quarterly payments, are due each year on April 15, June 15, September 15, and January 15 of the following year. If you don’t make these payments in a timely fashion and you don’t have other withholding occurring with your receipt of money, the IRS may penalize you for underpayment of tax when you file your tax return.

A little-known fact about IRA distributions is that when you have taxes withheld from the distribution (which are then sent directly to the IRS), the withheld money is considered to have been received throughout the year – even if it is received late in December. Using this fact to your advantage, you could figure out how much your total estimated tax payments should be for the year sometime in early December, and then take a distribution from your IRA in that amount. Here’s the trick:  Instead of taking the distribution yourself, fill out a form W-4P (or use your custodian’s form) to direct the total amount of the withdrawal to be withheld and sent to the IRS. Voila! You’ve now made even payments to the IRS for each of the four quarters, on time with no penalties!

The downside to this plan is that, in the event of the taxpayer’s untimely death before the annual distribution is made, the estimated payments will be considered as unpaid up to the date of death, and therefore the estate will be responsible for paying the underpayment penalty. Other than that shortcoming, this trick could provide you with several months’ additional interest/return on your money, plus remove the hassle of the quarterly filings.

But Jim, what if I’m retired and under age 59½? Won’t there be a penalty?

There doesn’t have to be, although I’d place this particular move into the “higher degree of difficulty” category of tricks – not to be taken lightly.

Why does this work? IRC Sec 6654(g)(1)

There is a section in the Internal Revenue Code related to income tax withholding from paychecks and other sources, specifically Section 6654(g)(1). Turns out that any withholding through the year at any time is credited as though they were paid evenly throughout the year. IRC Sec 6654(g)(1) states verbatim:

(g) Application of section in case of tax withheld on wages

   (1) In general

For purposes of applying this section, the amount of the credit allowed under section 31 for the taxable year shall be deemed a payment of estimated tax, and an equal part of such amount shall be deemed paid on each due date for such taxable year, unless the taxpayer establishes the dates on which all amounts were actually withheld, in which case the amounts so withheld shall be deemed payments of estimated tax on the dates on which such amounts were actually withheld.

   (2) Separate application

 

Therefore, by default, withholding from a paycheck, pension or other tax withholding source is considered to have been paid in ratably during the tax year, rather than credited when they were actually withheld. That doesn’t mean the taxpayer couldn’t specify timeliness of a particular withholding (if it was to the taxpayer’s advantage), this is an election the taxpayer can choose if they wish.

Pre-59½ Retiree: How to Avoid Penalty?

Same situation as before, but now you must take another step:  once you’ve taken the distribution and properly filed the W-4P (or custodian form) to have the distribution withheld as tax – execute a 60-day rollover, placing the same amount of money either into the same IRA or another IRA… effectively, you’ve pulled the old switcheroo with the IRS on this: you’ve paid tax with a distribution that didn’t happen!

How can this be?  Well, the IRS allows you to replace (or rollover) money from any source back into your IRA, so it doesn’t matter that your original distribution was used for withholding. So you have made up for missing all those quarterly estimated payments (no underpayment penalty now) plus by rolling over the funds you’ve avoided the 10% early withdrawal penalty as well.

Caveat

I mentioned that this last trick fits into the “higher degree of difficulty” category of tricks. The reason I say this is because using your account in this fashion (essentially a 60-day loan) can be hazardous – the primary reason is that 60 days is all you have, and 60 days can be a relatively short period of time. Plus, the IRS HAS NO SENSE OF HUMOR ABOUT THIS. If you miss the rollover period by one day, you’re outta luck.

In addition to the 60-day period, there is also the limitation of only one 60-day rollover per 12-month period. Again, remember: no sense of humor at the IRS. It is for these reasons that this rollover trick should only be used in the most dire of circumstances – such as if you completely forgot to make quarterly payments and are facing a stiff underpayment penalty, for example. Otherwise, I’d suggest leaving this one alone. By all means, you should not try this trick year after year. It shouldn’t be a problem if you’re over age 59½, though.