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A little-known fact about how withholding works for IRA distributions can work in your favor. While withholding from a paycheck and estimated tax payments are credited as paid during the quarter actually paid, it’s different for withholding from an IRA distribution.
When you have taxes withheld from a distribution from an IRA, no matter when it occurs during the calendar year, it is treated by the IRS as having been withheld evenly throughout the tax year. This means that if you had the bulk of your income in the first quarter of the year, you could take care of the tax burden with a distribution from an IRA and withholding enough tax even in late December of the same year, and there would be no penalty for underwithholding.
So – many folks find themselves in this position, especially in years when income is is not equal in each quarter, or if the tax burden was not known or misunderstood throughout the year.
This method could be used by anyone at any time, as long as you have access to your IRA funds. For example, if you are required to take a distribution, that is, if you’re over age 73 these days or you have an inherited IRA, you could use that distribution to cover your tax burden for the entire year (if it was enough).
Rather than making quarterly estimated tax payments throughout the year, toward the end of the year you could instruct your IRA custodian to distribute enough funds to cover the tax burden for the year (and don’t forget to include the amount of your IRA distribution in your calculation). Then you would also instruct the custodian to withhold the distribution as taxes, using form W-4P.
The one downside to this method is that if the IRA account owner dies before the distribution with withholding for the tax year (and let’s face it, this will probably happen at some point), then the estate will owe penalties for underpayment of estimated tax for that year.
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Also true for 401-k distributions.
Two comments. Firstly, I believe that all withholdings are treated as being throughout the year, so that includes withholding from a paycheck. Secondly, you don’t have to be 73 to withdraw from an IRA, that’s when RMDs currently start, 59 and a half is the age when you can withdraw without penalty.
I enjoy your emails and I’m surprised to see these errors.
Thanks for reaching out.
Technically paycheck withholding is credited pro-rata through the year (for the purpose of determining underpayment of estimated tax), but it’s reported quarterly to the IRS. This is different from IRA withholding, which is only reported annually, and thus the distinction. Call it an error if you like, give yourself one point. :)
However, I did not write that you need to wait until age 73 to put this into play – I used an example of someone who is subject to RMDs (at age 73) for illustrating one way to use this option. Of course this could be used at any age without penalty (if you meet one of the exceptions for the 10% penalty), and not just at or after age 59 1/2. An inherited IRA would be one such example. The intent of the article was not to illustrate every possible circumstance, just the more common situations. No points for this one.
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