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The income from the conversion is assumed to be spread over the 4 quarters.
Right, so I'm trying to figure out either how to minimize a penalty or avoid it completely. If I do this Roth conversion now, but haven't been paying estimated quarterly taxes, I'm trying to figure out (1) how large will the penalty be and (2) if it's large, if there are ways I can minimize it or eliminate it completely.
On (1), if the penalty is based on what I would have needed to pay quarterly to be in the 100% of previous year's tax safe harbor, it would be very small because I had a very small tax liability last year. If instead it's based on the say $10k I will owe this year in tax, my understanding is I could use form 2210 (schedule AI?) to make it clear that this income from the Roth conversion (which will be the vast majority of my income for the year) happened in Q4 and that is when I made a tax payment to cover that tax liability from the Roth conversion income.
Pay an amount of estimated tax now to cover your expected tax liability and you will be fine.
You are correct that if you only make an estimated payment, you can be subject to underpayment penalties for the previous quarters. I believe the penalty is based on the actual tax owed, not including a fudge factor for what the minimum correct estimated payment would have been.
To minimize the tax owed, you can do one of two things.
1. Pay the estimated tax in the quarter that you do the conversion, and then include form 2210 schedule AI with your return. This is the annualized income method of calculating the penalty, and it will show the IRS that your income was uneven and your payments in each quarter were correct for your income in each quarter. (Turbotax may not automatically trigger the penalty interview, but you can manually open the interview if Turbotax does not automatically run it for you.)
2. Have the tax withheld from the conversion. Withholding is assumed to be spread out over the whole year, just like income, so a penalty never evens comes up. For example, if you want to convert $10,000, have them withhold 22% and send you a check for $7800. You then send a check to the new Roth for $10,000 (by making up the difference from the funds you would have used to pay the estimated taxes). This is an indirect rollover, that you can only do once per year. The withholding will appear on your 1099-R.
Or, you can inquire of the receiving custodian if they will assist you in doing a rollover with withholding. For example, if you tell them "I want to roll over $10,000 but have withholding, can I have my plan send you $7800 and then I make an electronic payment of $2200 and we call it a rollover of $10,000?" I'm not sure this is possible but you can ask. Having withholding eliminates the need for a penalty calculation.
there are two basic rules to avoid underpayment of estimated taxes
to avoid penalties for underpayment of estimated taxes:
1) withholding and timely estimated tax payments must equal 90% of your current year's tax
or
2) withholding and timely estimated tax payments must equal 100% of the prior year's tax. this jumps to 110% of the prior year's tax if your prior year's adjusted gross income (line 11 of the 1040) is more than $150,000
$75,000 if married filing separate)
your goal is the lower of 1 or 2. since it seems you will have a significantly larger tax bill in 2024 than 2023, your goal would be the second option.
under either option, withholding is assumed to occur evenly throughout the year but if you're completing form 2210 you can use actual withholding for each period. estimates are counted for the period if made on or before their due date
With a large Roth conversion, I assume that, if nothing is withheld for taxes, the total underpayment for the year will be more than $1,000 and more than 10% of the tax owed. If that's the case, the penalty will be based on the quarterly underpayment of the amount needed to meet the safe harbor based on your 2023 tax liability.
Opus 17's suggestion #2 is probably the easiest way to avoid any underpayment penalty. Just be aware that the amount withheld for taxes will be uninvested until the check to complete the entire conversion is deposited into the Roth IRA.
Thank you all for the input, I greatly appreciate it! One thing I know I'm going to do going forward is pay quarterly estimated taxes to make sure I'm in the safe harbor, so I don't need to think more about it.
@jdbollinger wrote:
Thank you all for the input, I greatly appreciate it! One thing I know I'm going to do going forward is pay quarterly estimated taxes to make sure I'm in the safe harbor, so I don't need to think more about it.
One very simply option would be to make the conversion in the first quarter of the year instead of the last. That way, you can spread out the estimated payment over the whole year, and benefit from having that money in the mean time (maybe in an interest bearing account) and still be in compliance with the penalty rules. The IRS wants to see the estimated payment spread out over the whole year if the conversion is done late, but they also allow the payments to be spread out over the whole year if the conversion is done early.
It is important to keep in mind that for money contributed to a Roth or any IRA there must be "earned" income. The $2200 sent to the Roth account must have earned income for eligibility.
However you can set the conversion amount such that the net is $10K and the withheld amount will be added to the $10K rather than subtracted from it.
@ronroberts wrote:
It is important to keep in mind that for money contributed to a Roth or any IRA there must be "earned" income. The $2200 sent to the Roth account must have earned income for eligibility.
Not in the case of a rollover/conversion.
Thanks for clarifying! I must have been confused by your suggestion #2 above.
If the OP's investment house withholds $2200, sends him a check for $7800, and he then deposits $10,000, how is the $2200 a conversion/rollover? Where does the $2200 come from?
I am in a similar situation of likely needing to withdraw more from my tax deferred IRA this 4th quarter than I planned for in my first 3 estimated payments. The first 3 were for Roth conversions, but the next one will be for a new roof. Whether a conversion or just a withdraw, taxes will be owed in excess of what was planned in my earlier payments.
Will I avoid the hassle of form 2210 and Equalization of Income if my withdraw has taxes withheld? At the end of the year it will still look like my first 3 payments are less than 75% of total withdraws.
If my first 3 estimated tax payments plus money withheld from my future large 4th quarter withdraw exceed 90% of total tax due, does the IRS overlook the shortage on the 1st 3 payments?
@ronroberts wrote:
Thanks for clarifying! I must have been confused by your suggestion #2 above.
If the OP's investment house withholds $2200, sends him a check for $7800, and he then deposits $10,000, how is the $2200 a conversion/rollover? Where does the $2200 come from?
I am in a similar situation of likely needing to withdraw more from my tax deferred IRA this 4th quarter than I planned for in my first 3 estimated payments. The first 3 were for Roth conversions, but the next one will be for a new roof. Whether a conversion or just a withdraw, taxes will be owed in excess of what was planned in my earlier payments.
Will I avoid the hassle of form 2210 and Equalization of Income if my withdraw has taxes withheld? At the end of the year it will still look like my first 3 payments are less than 75% of total withdraws.
If my first 3 estimated tax payments plus money withheld from my future large 4th quarter withdraw exceed 90% of total tax due, does the IRS overlook the shortage on the 1st 3 payments?
On the question of withholding: withholding is always considered to be spread out over the year, even if it is not, the same as withdrawals. Suppose you withdraw $100,000 in December. The IRS just sees one 1099-R, so it assumes the withdrawal was spread out over the year, meaning the $25,000 tax you owe should be paid in 4 installments. If all the tax is paid in one installment at the end of the year, you are short for the first 3 installments unless you complete form 2201AI. However, withholding is also assumed to be spread out over the year, so if you withdraw $100,000 in December and have $25,000 withheld, the IRS assumes the money was withdrawn and the taxes paid in a timely manner, so you are not short in the earlier quarters.
On the question of completing the rollover, I would like to ask @dmertz to confirm.
One way to do the conversion with withholding, is to make the withdrawal in the form of an electronic debit or check to your bank account. You withdraw $10,000, have $2200 withheld, and receive $7800. Then, you send $10,000 to the new plan (by making up the difference from other funds). That's simple and easy, but you can only do that kind of rollover or conversion (where you get the money in between) once per year, and if you miss the deadline, you can get into more tax trouble.
Another way to do the rollover would be to make the withdrawal in the form of a direct transfer to the new bank, but with withholding, so you withdraw $10,000, have $2200 withheld, and have $7800 transferred to the new bank. Without more, that is a $7800 conversion, not a $10,000 conversion. My idea is that, if it is legal to do so, you tell the receiving bank "this is a $10,000 rollover, but $7800 is coming from my old plan and $2200 is coming directly from me." That way you get the benefit of a direct rollover, but you also get the benefit of rolling over the entire amount by making up the difference from other funds. @dmertz seemed to suggest this is acceptable, but the rollover is not "complete" until you send the makeup funds. But they didn't directly say this is allowable, so I'd like to double check.
In other words, it's just an alternative thought on how to rollover the entire amount but still have withholding to avoid the penalty, by adding your own make-up funds. Assuming it is allowable to do it that way.
"My idea is that, if it is legal to do so, you tell the receiving bank "this is a $10,000 rollover, but $7800 is coming from my old plan and $2200 is coming directly from me.""
That's what happens, but that's not what you tell the receiving custodian. As far as the Roth IRA custodian is concerned, the first transaction is a deposit of $7,800 as a Roth conversion. (The other $2,200 of the $10,000 is withheld for taxes, but the receiving custodian doesn't need to know anything about that.) Within 60 days of the original distribution the individual then makes a second deposit into the Roth IRA of $2,200 as an indirect Roth conversion to complete the Roth conversion of the entire $10,000 that was distributed from the originating account. The receiving custodian has no need to know any details other than these are deposits of Roth conversions. In fact, for an individual who is under age 59½, the $7,800 and the $2,200 are effectively two separate distributions which would be reported on separate Forms 1099-R, one for a $7,800 distribution with code 2 (assuming that the originating custodian has been told that the $7,800 is to be directly deposited into a Roth IRA) and the other for a $2,200 distribution with code 1 (the tax withholding). There is no limit on the frequency of Roth conversions, so there is no concern about these being considered to be separate distributions.
It's always a bit risky to tell the IRA custodian more than they need to know to perform the proper transaction.
Let me summarize how this works in Turbotax.
You contact the trustee of the pre-tax funds (IRA or 401k) and say, you want to do a $10,000 conversion to a Roth IRA, with $2200 (or 22%) withholding. Broker 1 sends $7800 to Broker 2 as a direct electronic transaction. Separately, you send $2200 to your Roth IRA at Broker 2 and tell them "this is also a Roth conversion." That's all you need to tell them. Broker 2 takes your word on it, they don't need to know more. (If you were lying, that's for the IRS to deal with, not the Roth IRA Broker.) You must deposit the money within 60 days of the direct transfer of the other part of the conversion, and be careful that you tell the plan in advance this is a rollover, so they don't accidentally record it as a regular contribution.
Then at tax time, you get 2 1099-R forms from Broker 1. One form says you converted $7800. You enter this in Turbotax and it goes through automatically. The second 1099-R says you withdrew $2200. Turbotax asks, what did you do with this money? and you check the box for "it was a Roth conversion."
That's it. Turbotax shows $10,000 converted and $2200 withheld, you get assessed the tax and credited with withholding, and the IRS does not issue a penalty because they see that the income and withholding match, and they don't consider the fact that the income and withholding occurred late in the year, because of how withholding is treated differently from estimated payments.
This will work for any size conversion, provided you can make up the withholding from other money and deposit it with the new Roth account within 60 days of the direct transfer.
Does that help?
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