Key Takeaways:
- Clients over age 59½ who take IRA distributions may be able to reduce or eliminate the need for quarterly estimated tax payments by increasing withholding on those distributions.
- The IRS treats IRA withholding as if it were paid evenly throughout the year, even if the transaction happens once, in December.
- This treatment can help avoid missed deadlines and remove the need to sell taxable assets to raise cash for the IRS.
- The strategy works best for clients already subject to Required Minimum Distributions.
- Coordination with a client’s accountant is crucial to avoid under or overpayment.
If you are self-employed, own a business, or have meaningful investment income, you are likely accustomed to paying quarterly estimated taxes. Many clients mail checks to the IRS for tax payment. While the IRS is still accepting paper checks, they are strongly encouraging the transition to electronic payments,
These tax payments can be tedious as they call for four calculations, payments, and deadlines each year. For clients who are already taking distributions from an IRA, there is often a simpler way. Having taxes withheld directly from your IRA distributions can replace some or all of your estimated payments.
Here’s how it works, when it makes sense and what to watch out for:
Who needs to pay estimated taxes?
The United States operates on a “pay-as-you-go” tax system. If you are a W-2 employee, your employer handles this automatically by withholding taxes from your paycheck. However, if you are a business owner, self-employed, or receive income that does not have taxes already withheld, you become responsible for making the payment to the IRS.
Generally, if you anticipate owing more than $1,000 in federal taxes for the year after accounting for any tax withholdings made throughout the year, then you are expected to make quarterly estimated payments.
What is the IRS Safe Harbor Rule for estimated taxes?
It can be difficult to accurately pay taxes throughout the year, especially if your income fluctuates as it may feel like shooting at a moving target. Fortunately, the IRS provides a Safe Harbor Rule which if conditions are met, can protect you from potential underpayment penalties. Your safe harbor payment options can vary depending on whether your prior year’s adjusted gross income (AGI) is above or below $150,000. This $150,000 threshold applies to both single filers and married couples filing jointly. For married couples filing separately, it is $75,000.
If your prior year’s AGI was $150,000 or less, you can generally avoid an underpayment penalty by paying either:
- 90% of what you owe for the current year, or
- 100% of what you owed last year
If your prior year’s AGI was above $150,000, you can generally avoid an underpayment penalty by paying either:
- 90% of what you owe for the current year, or
- 110% of what you owed last year
In practice, it is typically easier to satisfy the prior-year safe harbor requirement (100% or 110%) as it is based on a known and finalized figure from last year’s tax return. Solving for 90% of the current year requires projecting out your income through the end of the year, demanding precision and ongoing monitoring throughout the year.
What are advantages of withholding from an IRA?
One of the unique benefits of withholding taxes from an IRA is that the IRS treats taxes withheld from a retirement account as if they were paid evenly throughout the year, regardless of when the withholding occurred. This means that a single withholding in December is treated as a quarter of it was paid in each period.
This differs from estimated taxes as the payment is credited on the date it is received. If you skip the April and June installments and make a larger catch-up payment in December, the IRS views this as two late quarters and can assess an underpayment penalty.
This provides several benefits for clients who are over age 59 ½ and are distributing from their IRA.
Simplified Tax Management: Rather than calculating and submitting four payments, your custodian sends the money directly to the IRS. This eliminates the need to mail checks or log into an online portal to pay.
Year-End Safety Net: If you reach the last few months of the year and realize your income ran well ahead of projections, or that you simply missed a quarter, a larger year-end IRA withholding can retroactively cover the shortfall and eliminate a penalty that an equivalent estimated payment would not cover.
Liquidity in taxable accounts: Writing estimated tax checks throughout the year means keeping cash in hand, and potentially triggering capital gains to raise cash. If you are subject to Required Minimum Distributions (RMDs), you can withhold taxes on these distributions that are required to be withdrawn anyways.
What should I consider before switching to IRA withholding?
This approach is not right for everyone, and it is important to discuss these details with your tax advisor.
It works best if you are already taking distributions. The strategy is most natural for clients that are subject to (RMDs) or who are otherwise drawing from retirement accounts to fund their spending.
Withheld amounts are still taxable income. Money withheld for taxes counts as part of your gross IRA distribution. If you need $10,000 withheld, that $10,000 comes out of the IRA and is included in your ordinary income for the year.
Age matters. IRA distributions before age 59½ are generally subject to the 10% early withdrawal penalty. This strategy is primarily for clients beyond this threshold.
Look at your other income sources. If your pension or Social Security benefits have insufficient tax withholding, adjusting the withholding on your IRA distribution can absorb the gap and may eliminate the need for estimated payments altogether.
Monthly distributions need a slightly different approach. If you take your RMD in monthly or periodic installments, we generally recommend withholding taxes throughout the year and reserving December (or your last distribution in the calendar year) for smaller withholding adjustments if needed. By this point in the year, most of your RMD has likely been satisfied already. Because the gross distribution is taxable whether paid directly to you or withheld for taxes, withholding levels should be coordinated carefully with your broader tax and cash-flow needs.
Roth conversions add a wrinkle. If you are subject to RMDs, the RMD must be satisfied before any Roth conversion. If your RMD is $100,000, only distributions beyond that $100,000 can be converted. That said, you can increase the withholding on the RMD portion to cover the taxes generated by the conversion.
Why is communication so important here?
Whatever approach you take, everyone involved needs to be on the same page. If you have already made estimated payments and then add withholding on top, you may substantially overpay. If your accountant is unaware that withholding is now covering your obligation, they may continue to prepare quarterly vouchers.
We coordinate directly with clients’ accountants throughout the year, sharing year-to-date investment income, realized gains, and withholding figures so that the plan holds together and you avoid any surprises at tax time.
Wondering whether this makes sense for your situation? Reach out to your Client Service Team. We can review your prior-year safe harbor figures, look at what is already being withheld from other income sources, and determine whether shifting from estimated tax payments to IRA withholding is a suitable method for you.
This material is provided for informational and educational purposes only and should not be construed as tax or legal advice. The concepts discussed may not be appropriate for all individuals and are based on current federal tax laws, which are subject to change. Any examples provided are for illustrative purposes only and are not intended to predict or guarantee any particular outcome. For legal advice, consult with a licensed attorney. For tax advice, consult with your tax adviser.
