Withholding Tax Without Income?

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We’ve discussed in the past how it’s possible to eliminate quarterly estimated tax payments by using a withdrawal from your IRA. But did you know that you can put this method in motion without actually increasing your income?

Wait a minute… did you just catch that? I’m telling you that you can eliminate your withholding or quarterly estimated taxes by using a withdrawal from an IRA – and that you can do this without having to recognize income from the IRA withdrawal.

It’s a little tricky, but if you’re not too faint of heart, this could actually be a cool little maneuver. What you do is to take a withdrawal from your IRA, and on the withdrawal slip indicate that you want the entire withdrawal withheld for taxes. Then, within 60 days, replace the funds (from another, non-IRA source) into either that same IRA or another IRA – completing a sixty-day rollover. End result: taxes withheld, no income, no penalty.

While it might seem crazy to assert that you can have taxes withheld from a distribution that was negated by a 60-day rollover, but the IRS allows you to do a tax-free rollover of a distribution that has been sent to the IRS as withheld income tax, by using substitute funds (see Reg 1.402(c)-2, Q-11).

What’s so cool about this maneuver? Take these factors into account:

• When you withhold tax from an IRA distribution, the IRS considers that it has been withheld over the course of the year, so timeliness of withholding isn’t important: you could have your entire tax burden withheld on December 31 if you wanted. If you tried this with non-IRA funds, only making one estimated tax payment (or withholding payment), the IRS would hit you with an under-withholding penalty for not sending the money to them throughout the year.
• If you are self-employed or otherwise in complete control of your income, you can eliminate withholding and/or estimated tax payments completely, by saving up the equivalent of withholding through the year and then pulling the trick outlined above toward the end of the year.

You’d be able to very accurately calculate your tax payments, reducing the loss of income that comes along with over-withholding through the year. This way you can invest the money that you’d otherwise be sending in quarterly installments, and at the end of the year make one large payment from your IRA, and roll-in your withholding stash.

It should be noted that, while this is a valid option to consider, there are pitfalls that could really cause you problems. Just forgetting to do the IRA withdrawal (withholding the withdrawal to pay tax) on time can result in some very serious penalties. Furthermore, missing the 60-day deadline for completing the rollover could penalize you further with the 10% early withdrawal penalty. To simplify things, you should complete the rollover within the same tax year if at all possible.

In addition, keep in mind that there’s a once-per-year limit on these 60-day rollovers. So if you wanted to try this on a regular basis year after year, you’d need to time things properly to keep from hitting up against your 12-month restriction on repeated rollovers.

I would not suggest doing this maneuver on a regular basis – it should be one of those tools that you have available if you get caught in a pinch. The penalties for screwing it up are severe, and the chances of screwing it up are plenty.