Owing Taxes Multiple Years in a Row

[CRM]

I need some guidance for future years. I will owe the IRS for tax year 2018 due to a Roth conversion. The amount is significant. I will pay the amount in full by the April 15th filing date. I'd like to another conversion in 2019. A conversion will likely result in me owing for Tax year 2019 as well. My question is: if I accept that I will owe, but pay off the amount before the filing deadline, is there any penalty? I can't seem to find an answer related to this scenario. It should be noted that this is partially due to intentional underwithholding from W2 income

[Carl]

When converting large amounts from a tax deferred retirement account to a taxable ROTH account, this can create a PITA on the tax front.  The IRS computers see a sudden "jump" in taxable income for that quarter and can potentially flag it for underwithholding penalties on the W-2 withholding tax front, or underpayment penalties on the quarterly tax front.  This results in a computer generated underpayment/under withholding penalty be assessed, and no human at the IRS will be aware of this unless and until *YOU* say something to a living human at the IRS. That's what as the potential to make this a real PITA.

However, you can avoid the possibility of this headache if you pay your taxes on the converted amount as a quarterly tax payment, in the quarter the conversion (or conversions if done more than once in a tax year) take place.  It's easiest to do online at www.irs.gov/payments.

[CRM]

Thanks for the suggestion. Last year I did the conversion all at once. Would I be better off spacing it out, while upping my withholdings on my W4 to offset the increase in tax burden?

At the end of the day, if I make sure by the 2019 filing that I've covered my tax liability, does it matter? Or am I opening myself up to addition risk, like an underpayment penalty?

[Carl]

This response is lengthy and probably contains information you already know. But I'm posting  for the benefit of others reading this thread to. So please bear with me.

First, the 2018 tax brackets for someone who is filing single only. The basics here do apply to those not filing single. But I'm trying to "keep it simple" here for the sole purpose of educating folks on this.

$0 to $9,525 is taxed at 10%

$9,526 to $38.700 is taxed at 10% on the first $9.525 and 12% for the amount over that.

$38,701 to $82,500 is taxed at 10% on the first $9,525, 12% on the next $29,174 and 22% on the amount over that.

$82,501 to $157,500 is taxed at 10% on the first $9,525, 12% on the next $29,174, 22% on the next $74,999 and 24% on the amount over that.

Okay, the above four tax brackets are enough to work with here for my purposes.

Lets say before you convert anything that your taxable income is $75,000. Using the above formulas, your taxes on $75,000 of taxable income will be

$925.50 on the first $9,525 (10%)

$3500.88 on the next $29.174 (12%)

$7,986 on the remaining $36,301 (22%)

Total tax liability is $12,412.38

Now lets convert $25,000 of a traditional IRA to a ROTH. Total taxable income is now $100,000.  Taxes on the converted amount that puts my taxable income over $82,500 is taxed at 24%. I'd be better off converting only $7,500 this year as that would put my taxable income right on the mark at $82,500 and it's only taxed at 22%.

Then in 2019 I will wait and "work the numbers" at year end to see what I can convert and still keep myself in the same tax bracket I would be in, if I did not convert.

[CRM]

Thanks for the reply Carl, appreciate you taking the time on this

The strategy laid out is sound, however it isn't really applicable for me since the conversion won't move me into a new tax bracket.  My primary concern ties back to your first post about underpayments and quarterly tax payments.  If I do a $20K conversion in Q1 of 2019, up my withholdings on my W4, and still owe by the time I file my 2019 taxes, have I introduced any additional risk or cost that I'm not thinking of since I'm underwithheld over the course of a year?  I'm primarily concerned about underpayment penalties

For background, I converted $20K in 2018, but did not up my withholdings, and as I work through my taxes, I'm going to be underwithheld in 2018, but I will pay the entire amount before April 15 2019.  So by the filing deadline, my balance will be zero.  If I do the same in 2019, with the same situation (convert $20K, underwithhold, pay the entire balance by April 2020), will I run into an issue?  I've seen that 2 consecutive years of owing large sums at tax time results in an underpayment penalty, but I read that as only applying to folks who do estimated tax payments on a quarterly basis.  I do not do quarterly estimated tax payments, although maybe I should be?

[Carl]

To my knowledge, the 2018 tax law changes do not affect this. But here's how I understand it, and have experienced it myself in the past.

If at the time you file your taxes, if what you owe the IRS at that time is more than $1000 or more than 10% of your total tax liability (whichever is higher), then an underpayment or under withholding penalty is assessed.

Now there are ways to get that waived. But why create more paperwork for yourself, right?  You have two choices, and can even do a combination of both if you want. Either up your W-2 withholdings, or pay yourself as estimated tax directly to the IRS in the quarter the transaction occurs, or a mix of both.

But even if you do neither, so long as you are within the above mentioned limits at tax filing time, no penalties would be assessed.

[CRM]

This answer is perfect. Thanks for taking the time

[NCperson]

easier approach....convert to the ROTH when you want to and make the estimated payment to the IRS at the same time.  Then fill out form 2210 at tax time and it'll accommodate 'lumpy' income so that any penalty is minimized.