Underpayment penalty

[rj_nc]

During 2023 I encountered an underpayment penalty from both the IRS and State that appear to be due to a Roth Conversion and RMD from an inherited IRA performed late in the year (December). Despite having paid more tax than owed and more taxes than 2022 - the IRS still imposed the penalty and would not provide any relief. Note that I did pay estimated quarterly taxes based on income calculations for each quarter throughout the year.

In researching the situation it appears that my paying the taxes as part of the Q4 estimated tax payment may be part of the issue. I understand that had I elected to withhold taxes as part of the Roth conversion and as part of the inherited IRA RMD distribution - the same amount of taxes would have been paid but the underpayment penalty would have been avoided.

Can someone confirm or refine the understanding above? I will likely have a similar situation again this year and would like to avoid the underpayment penalty. 

[KimberW · Accepted solution]

Estimated payments are calculated four times during the year. If your actual income for the first three months of the year is quite high, then the estimated taxes for that first payment should also be higher. It isn't a system where you can 'catch up' by making a large payment with the fourth estimated payment.

Withholding, however, is treated as being paid throughout the year -- regardless of when it actually happens. So, yes, having taxes withheld from one-off payments such as RMDs and conversions could help reduce any underpayment penalty.

Another way out of an underpayment penalty is to report to the IRS the actual timing of your income. For instance, if it's your fourth quarter of income that is substantially higher than the rest, then your fourth quarter estimated payment should be the one that's higher. It's not just higher to catch up with early-in-the-year income. This is referred to as "annualizing" your income and could potentially provide some relief. More information about how to avoid this penalty in this article: What is Form 2210? 

[FranklinF]

Having DISIMILAR QUARTERLY INCOMES may cause underpayment of taxes on one or more of the quarterly periods leading to underpayment penalties. THE ANNUALIZED INCOME INSTALLMENT METHOD recalculates estimated tax payment installments so it better relates to when the taxpayer earned the money in the year. Its purpose is to limit both the underpayment and its corresponding underpayment penalty associated with uneven payments when a taxpayer's income varies throughout the year.

Having taxes withheld from a W-2 or a 1099 form is another way to reduce the underpayment of penalties because payments made in this manner are considered evenly paid throughout the tax year regardless on when the payments were made within the tax year in question. 

Finally, the form used for the above calculations is  IRS FORM 2210 

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[rj_nc]

Thanks Franklin. Unfortunately, since I'm retired, I don't really have the W-2 withholding option. I think the 1099 option (withholding reflected on the 1099 showing the distribution) is my best option.

I thought that I had captured the disparity in "income" between Q's 1-3 and Q4 as part of my tax forms but the IRS seemed to disagree. Fortunately the penalty was small enough to consider a "wake up call" for this year and wasn't worth a bigger "fight". 

Hopefully I won't have a repeat this year by going the 1099 route.

[rj_nc]

Thanks Kim - great advice!

I think that between increased estimated quarterly payments and shifting to having the taxes withheld as part of the distribution/conversion (and reflected on the 1099) - I shouldn't have a repeat of last year.