Inherited 401k Tax Withholding

[Frank51281]

Hello,

I have an inherited 401k account (non spouse) that I was given bad information on by Fidelity in 2019. Basically I was told I had 10 years to cash it out, when in reality, I only had 5 years due to the family member passing in 2017 before the law was changed to the 10 year rule around 2019 or so (this past Monday 10/24 was 5 year since date of death). 

Unfortunately thanks to this bad information Fidelity just automatically cashed out the entire 401k on the 5 year date which was this Monday, they withheld 20% federal taxes and mailed me a check for the rest. It would have been nice if they contacted me and informed me what was going on so I could have chosen to withhold more. 

My question is, do I need to make an estimated tax payment now to cover the discrepancy between the 20% they withheld, and approximately what I will actually owe, or can it just wait until I file my taxes? For reference, based on my regular annual income this year, just about all of the 401k money distributed will be in the 24%, 32%, and 35% brackets, so the 20% withheld is low. This is a total disaster.

Thanks for any advice.

[fanfare]

Disaster?

Make an Estimated Tax payment before you spend or invest that money and you won't have to worry about Tax Day.

@Frank51281 

you can pay on the irs website or EFTPS.gov

[Opus 17]

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@fanfare wrote:

Disaster?

Make an Estimated Tax payment before you spend that money and you won't have to worry about Tax Day.

@Frank51281 

you can pay on the irs website or EFTPS.gov

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I wouldn't use EFTPS, no need to set up an account.  Just go to www.irs.gov/payments.  Make sure to select "2022 estimated taxes" from the menu of reasons for the payment.  Don;t forget you may also owe an estimated payment to your state, state taxes at that income level will be between 7-13% depending on your state. 

While you could have spread out the money over 2017-2022 if you had better advice to begin with, since it all has to be withdrawn in 2022, it doesn't really matter for tax purposes if it happened all at once or spread out over the year.  

[Frank51281]

By disaster, I meant that I did not intend to take ALL of this money in one year. I planned to withdraw over at least two or three years to spread out the tax liability, but I was given wrong information by a Fidelity Rep and now I am forced to take it all in one year, while the account is also down 20%+ from the market this year.

I am not concerned with spending or losing the money. I just want to make sure if I wait to pay the tax when I file next year, that I won't be charged any penalty by the IRS for not withholding enough during the tax year. If that makes sense?

[Frank51281]

I will probably just calculate what I will owe to federal and state, and make both estimated payments once the check is deposited and be done with it. As I understand, it's "pay as you go" and I don't want to risk any penalties later for not withholding enough tax now. Thanks for the links.

[fanfare]

why do you want to wait and risk a penalty?

do you think you can invest that money and make it grow in six months?

See Instructions for Form 2210 to see the rules that if satisfied will guarantee you cannot be penalized no matter how much more income you have this year.

@Frank51281 

[Frank51281]

I don't want to risk a penalty. I have never had to deal with anything like this before so I was doing research and learning about possible penalty. It's certainly a significant amount of tax that has to be paid. Risking the money via investment in order to grow it (especially in this market) would not be a wise decision so I will just make the payments now. No sense to delay the inevitable. Thanks!

[Opus 17]

@Frank51281 

To clarify a couple of points.

If the withdrawal is happening now, the estimated payment is due January 15, 2023.  Whether you want to risk any gains (or losses) during that time is up to you. 

Second, to avoid a penalty, you only need to make payments in the system equal to 110% of your previous year‘s tax liability.  Your tax liability is the net amount the government kept, after considering all of your withholding, payments, and refunds. For example, if you had $12,000 of withholding and got a $2000 refund, your tax liability was $10,000.

To avoid a penalty, you only need to make a large enough estimated payment so that your 2022 withholdings plus estimated payments equals at least 110% of your 2021 tax liability. For example, if your 2021 tax liability with $10,000, you only need to pay enough estimated taxes so that your estimates plus your current withholdings will equal at least $11,000.

The remainder of the tax would be due April 15, but you would not be charged interest or a penalty.  You might be able to invest difference in the meantime, but of course there are risks.

[Frank51281]

@Opus 17 Thanks so much! I was reading a little about this in the form 2210 that @fanfare mentioned. So in my situation, just the 20% federal tax that Fidelity withheld before cutting the check will FAR exceed the 110% of my 2021 tax liability by itself so I can just pay the rest when I do my taxes and not fear any penalty. In the mean time, I can at least let the money gain a little interest for a few months. However minimal it will be, it's something. I am not likely going to risk investing any in the market at this time. Now I will just look into the rules for state tax (NJ in this case) but I will probably just make the payment on that now since it's much less than Federal anyway. 

Thanks to everyone who replied.