TurboTax is estimating penalty for year end Roth conversion - its requiring estimated tax to be paid through out the year

[naras-tx]

I have a small business, and the income from this business mostly goes in to SEP IRA/401K, so there is no taxable income.  But there is self employment tax, and I have paid in the first quarter all of Self Employment tax along with 1040-ES.   

At the end of the year (last week of December), I decided to do a large Roth Conversion, which led to additional tax I owe.  I decided to pay 1040-ES by 1/15 to cover this tax. But when I do the tax using Turbo Tax, it assumes the tax is due through out the year, and calculating a penalty.

I have read about "annualizing" the income to avoid this penalty.  Is there a way to do this in Turbo Tax?  How do I avoid the penalty in Turbo Tax?

[Carl]

For clarity, whoever can help here, the OP is well aware this conversion will most likely put them in a higher tax bracket. The "penalty" they are talking about is the underpayment penalty for not having paid enough in estimated taxes throughout the year. They should not have to pay this for this specific situation. I can't see in TT 2017 how to avoid the program figuring the penalty. It's gotta be doable, as people do these conversions all the time, and have been for years.

[dmertz · Accepted solution]

Go to Other Tax Situations -> Additional Tax Payments -> Underpayment penalties.  Click through the pages and verify the entries until you reach the Annualized Income Method page.  Click Yes, you want to annualize.

To annualize, you must allocate your various income, deduction and tax payment amounts to each of the tax quarters of the year.  The entries will be made as amounts for Q1, Q1+Q2, Q1+Q2+Q3 and full year.  It's a rather onerous process to determine the allocations, but the result in your case will be that the conversion amount will only be present in the full-year income entries and your Q4 estimated-tax payment will take care of it.  Check the results by examining the Form 2210 and 2210 Penalty Worksheet generated by TurboTax.

You'll likely need to do the same for your state tax return.

[dmertz]

For a potentially simpler situation in the future, you might consider having taxes withheld from conversion distribution and completing the conversion of the entire gross amount using other funds.  Unlike estimated tax payments, withholding is by default treated as having been withheld in equal portions throughout the year.

[naras-tx]

Thank you for the detailed answer on how to do this in Turbo Tax.  I tried it, and sure enough it works great.  I appreciate your help.

On the comment you made about withholding, Its easier if it is withdrawal from IRA.  But conversion from traditional IRA to Roth IRA become more complex.  To do a withholding, an additional amount need to be withheld, thus increasing the withdrawal.   It also gets into recursive issue.  Although not in my case, in some cases it may lead to early withdrawal penalty.  In addition typically most firms would do a 10% withholding (although I believe this can be changed by request).  At least in my case that 10% would be too high, due to other deductions etc.  I still have not done it yet (for 2017) - I will call my brokerage and see if they can do proper with holding.  

For standard withdrawal from IRA, I am in total agreement with you, doing a withholding is the right thing to do.  

Thanks for your help and comments.

[dmertz]

On an IRA distribution, you can have them withhold 10% by default, request that nothing be withheld or request that more than 10% be withheld.  (Withholding on less then 10% can be accomplished by splitting distributions into two.)

There is no recursive issue when converting to Roth.  You can simply reduce the amount that gets transferred to the Roth IRA so that the total Roth conversion contribution plus the amount withheld for taxes would be the same as you would have otherwise had distributed to you.  In addition, you can even complete the Roth conversion of the amount withheld for taxes by using other funds.  Let's say you want to distribute $20,000 from the traditional IRA or qualified retirement plan to result in 10% or $2,000 of additional tax liability.  Your initial distribution can be to convert $18,000 to Roth and withhold $2,000 for taxes.  Optionally, you can use the $2,000 from savings to within 60 days make a conversion contribution of the $2,000 distribution that was withheld for taxes.  If you do this, the net would be the entire $20,000 converted to Roth and $2,000 of tax withholding instead of $20,000 converted to Roth and $2,000 of estimated tax payments.  Otherwise, you leave it as $18,000 converted to Roth and $2,000 in taxes, still $20,000 distributed.

[sonzoil]

So I took an IRA distribution in December of last year, and put the proceeds back, converting to a Roth IRA for the same amount.  Does it pay for me to annualize the income, since I did this in December, to lower my $45 penalty for underpayment for the whole year?

[sonzoil]

 I took an IRA distribution in December of last year, and put the proceeds back, by converting to a Roth IRA for the same amount.  Does it pay for me to annualize the income, since I did this in December, to lower my $45 penalty for underpayment for the whole year?  Also, should I use the annualization method to determine my taxes on my Massachusetts return?  On the Mass form, it shows total yearly income as $10K less than it should be?

[GeorgeM777]

Yes, it is worth the effort to see if annualizing your income will reduce or eliminate your proposed tax penalty.  The annualized income installment method is a pay-as-you-go method to calculate the required quarterly estimated tax payments. You may receive income, such as business income, bonuses and capital gains, unevenly throughout the year.  In your case, you mentioned that you took an IRA distribution in December 2021.  Because you earned more income in late 2021 than you probably did in the early part of 2021, you can reduce your quarterly estimated tax payments by paying the tax based on actual quarterly tax projections. 

In connection with using the annualized income method, TurboTax will prepare for you Schedule AI.  Schedule AI will annualize your tax at the end of each payment period based on your income, deductions and other items relating to events that occurred from the beginning of the tax year through the end of the period.

@sonzoil

[sonzoil]

So I have a $45 penalty on federal, and about the same on Massachusetts, since I did not file quarterly payments at any time in 2021.  Three fourths of my income for the year, came with that IRA distribution in December.  So it is worth it to annualize both fed and state to lower the penalty?  I know I will have penalties anyways, I just don't want to find out after all the work that I saved $5.  

[ErnieS0]

It depends on your total income and the amount of your IRA distribution. You've have to do the calculations to find out. If you federal and state penalties totaled $90, that would be the maximum savings @sonzoil.

Alternatively you can request a penalty waiver, if applicable.

The law allows the IRS to waive the penalty if:

1. You didn't make a required payment because of a casualty event, disaster, or other unusual circumstance and it would be inequitable to impose the penalty, or
2. You retired (after reaching age 62) or became disabled during the tax year or in the preceding tax year for which you should have made estimated payments, and the underpayment was due to reasonable cause and not willful neglect.

Topic No. 306 Penalty for Underpayment of Estimated Tax

[sonzoil]

Do you have any idea why in the computation page for Massachusetts annualization for quarterly amounts, it shows the total year being auto populated as almost $10,000 less than my federal adjusted gross income?

[sonzoil]

Do you have any idea why in the computation page for Massachusetts annualization for quarterly amounts, it shows the total year being auto populated as almost $10,000 less than my federal adjusted gross income?

[sonzoil]

Concerning if I should annualize my return for fed and state.  I assume I would have to annualize both to lessen the tax penalty assigned by both?  If I decide after checking option to annualize, can I back out of this later, and decide not to in the program?  I know I have to calculate income to each quarter, but do I have to do the same for interest and dividend income, and money made with exempt bond interest, etc?  My federal AGI, is much more than my state of Mass amount shown for the prepopulated field in annualization program for Mass. Have any idea why this is so?

[RobertB4444]

@sonzoil  As @ErnieS0 told you the annualization has to be entered to reduce the penalty.  If all of your income lands in December you should be able to reduce your penalty.  If you change your mind and decide not to annualize you just need to go back and change the check box from annualize to don't annualize and you're all set.  

As for why Massachusetts income is lower than federal it would depend on what type of income you have in your return.  Massachusetts has different rules for what is taxable than the federal government, as well as what is deductible.