Tax Withholding and Roth Conversions
A recent call with a financial advisor in Ohio who works with Pentegra is representative of a common question on tax withholding as it relates to retirement accounts.
A client of the advisor executed a large Roth conversion in the fourth quarter of last year and the IRS subsequently notified her that she owed a penalty because of underpayment of estimated taxes. How did this happen and what can she do about the penalty?
Let us first review the rules concerning the timing of tax payments. Generally, the IRS requires at least 90 percent of taxes owed throughout the year through withholding, estimated or additional tax payments or a combination of the two, payable before the April 15th tax filing deadline. Many individuals make quarterly estimated tax payments to avoid underpayment penalties.1
However, certain retirement-related transactions, such as large taxable distributions from IRAs, 401(k) plans, Roth conversions, etc., may trigger a penalty assessment from the IRS. Recall in this situation, the client made a large Roth conversion in the fourth quarter of the year. Unfortunately, the IRS assumes that taxable income from transactions like these occurs throughout the entire tax year. Thus, from the IRS’s perspective, the large fourth quarter Roth conversion occurred throughout the year and because the individual did not make estimated tax payments in the first three quarters, she owed a penalty.
Fortunately, the client may be able to request a penalty waiver by filing IRS Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts. The client would note the large Roth transaction occurred in the fourth quarter and, therefore, quarterly estimated taxes should not be due for the first three quarters. As with any tax-related matters, individuals should work closely with their tax advisors for correct completion of Form 2210.
Conclusion
Any time a client has a late-year, large retirement-related taxable event, such as a Roth conversion or any large distribution, a discussion with a tax and/or legal advisor about its tax implications or how IRS Form 2210 may be used to request a penalty waiver is warranted.
1 IRS Basics of Estimated Taxes for Individuals
The information set out herein is for general information only and is not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.