Estimated tax payments dependent on unknown-size year-end IRA withdrawal

[bextel]

This is the first full year I am receiving Social Security.  I also have an IRA.  I usually make a withdrawal from the IRA at the end of the year, with the amount varying on my current financial needs and some other factors.  But IRA withdrawals go into Adjusted Gross Income, which in turn goes into the formula that determines whether -- and how much -- federal tax I will have to pay on my Social Security benefits.  In my case it can make a big difference.  (SS and any IRA withdrawals I make are the bulk of my income.)

Now, if my  year-end IRA withdrawal is one that takes me into the range where my SS income is taxable, will I be charged a penalty for not having made estimated tax payments during the year?  If the answer is yes, how do I know how much estimated tax to pay, when I won't know until year-end what my IRA withdrawal will be? 

On a similar note, what if I don't make an IRA withdrawal this year, but -- at year's end -- come into some other income that makes, say 75% of my SS benefits taxable?  Same questions:  Would I be penalized for not having made estimated tax payments?  And how would I have known how much they should be "in advance"?

[Opus 17]

Yes, you can be penalized.  The IRS assumes that all income is paid out evenly over the year, and all taxes should be paid evenly over the year, either via withholding or via quarterly estimated payments.  If you have a lump sum of income at the end of the year, the IRS will assume that a quarterly payment was due April 15, June 15, and August 15 (in addition to a final payment due January 15, 2025) and you can be assessed an under-payment penalty even if you pay in full when you file.

You can partly overcome this by including form 2210 with your tax return (to calculate the penalty) and use the optional annualized method.  This allows you to show that your income was irregular, and that your tax payments and withholding in each quarter were appropriate for the amount of income in that quarter.  However, this won't fix your entire problem, because even if you show a lump sum IRA withdrawal in the 4th quarter and a corresponding 4th quarter estimated tax payment, you will still be under-withheld on your social security for all 4 quarters.

https://www.irs.gov/payments/underpayment-of-estimated-tax-by-individuals-penalty

https://turbotax.intuit.com/tax-tips/irs-tax-forms/what-is-form-2210/L2z0haVWb#%23

I suggest you adjust your tax withholding from social security so that it covers the highest tax you might reasonably pay on your social security.  For example, an average middle class single adult will be between 12% and 22% tax on 85% of their social security, depending on the amount of the IRA withdrawal.  So you might choose to have 15% or 18% of your social security withheld each month.  Then when you make your IRA withdrawal, you can perform an estimated tax calculation and pay any lump sum tax you might owe, and include form 2210 with your return.   If you overestimate the payment or withholding, you will get the difference back as a tax refund.

You can also use various withholding estimators including this one at the IRS.

https://www.irs.gov/individuals/tax-withholding-estimator

Plug in your basic information, and run different scenarios with different IRA withdrawals, to get a feel for the range of tax you should have withheld monthly to cover your taxes for the year. 

[fanfare]

What is your 2023 tax ? do you have withholding taken in 2024?
If your total 2024 withholding alone is 100 % of that amount ( 110% if your 2023 AGI is over $150,000),

You don't need to make estimated tax payments. This is the prior year's tax rule.

If you got a 2023 refund this year and 2024 earnings are comparable then your 2024 withholding may already meet the prior year's tax rule

 One possible action is to make sure your withholding instruction to custodian on IRA distribution specifies the needed withholding to satisfy the rule.

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meanwhile Estimated Tax payments may be prudent to ensure meeting your Tax Day obligation.

@bextel 

[bextel]

Thanks Opus 17, very helpful info and suggestions.

SS aside, I didn't realize that the IRS expects income that is mostly received in December to be paid out evenly throughout the year. I haven't been doing that, but instead withholding my expected tax burden from the year-end IRA distribution.  Yet haven't been assessed a penalty.  I guess I've been lucky.  (Although other factors may have partially contributed, including paying about 10% withholding on a modest monthly pension I've had for awhile; and -- maybe half the time -- ending up paying withholding that exceeds my previous year's total tax.)

EDITED to correct a misstatement.

[bextel]

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@fanfare wrote:

meanwhile Estimated Tax payments may be prudent to ensure meeting your Tax Day obligation.

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That's certainly beginning to look advisable.

[fanfare]

"instead withholding my expected tax burden from the year-end IRA distribution. "

That's exactly what I suggested above.

Withholding at least 90% of your tax burden will eliminate any penalty. (the current year rule).

withholding needs to meet only  the smaller of the two rules.

@bextel 

[bextel]

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@fanfare wrote:

"instead withholding my expected tax burden from the year-end IRA distribution. "

That's exactly what I suggested above.

Withholding at least 90% of your tax burden will eliminate any penalty. (the current year rule).

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So you are suggesting that it's NOT necessary to make quarterly payments as long as I withhold 90% of my year's tax from the year-end IRA distribution?   Is this any different in the IRS's eyes than sending in an estimated tax payment for 90% of the year's tax in the last quarter (even for someone who receives income distributed evenly through the year)?  Then why wouldn't everyone avoid the penalty for non-timely withholding payment this way?   Or is there something about the scenario I presented that makes it different, such as the fact that IRA distribution was all at year-end -- which @Opus 17 said doesn't eliminate the need for quarterly payments?  (Please consider my initial Social Security related question in the response.)  Thanks!

[dmertz]

Tax withholding is treated as paid evenly throughout the year while estimated taxes are treated as paid when actually paid.  By pay the tax via withholding from the IRA distribution, portions will be applied to earlier tax quarters.

[Opus 17]

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@dmertz wrote:

Tax withholding is treated as paid evenly throughout the year while estimated taxes are treated as paid when actually paid.  By pay the tax via withholding from the IRA distribution, portions will be applied to earlier tax quarters.

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I believe this is only true if you use the annualized method on form 2210.  If you don't, I believe this still counts as an underpayment. (For example, if you sell stock or your house and have a large capital gain in December, it is not enough to make a January 15 payment unless you also use the annualized method on form 2210.  I have seen other questions here posed by taxpayers who were penalized for this situation. 

[Opus 17]

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@bextel wrote:

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@fanfare wrote:

"instead withholding my expected tax burden from the year-end IRA distribution. "

That's exactly what I suggested above.

Withholding at least 90% of your tax burden will eliminate any penalty. (the current year rule).

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So you are suggesting that it's NOT necessary to make quarterly payments as long as I withhold 90% of my year's tax from the year-end IRA distribution?   Is this any different in the IRS's eyes than sending in an estimated tax payment for 90% of the year's tax in the last quarter (even for someone who receives income distributed evenly through the year)?  Then why wouldn't everyone avoid the penalty for non-timely withholding payment this way?   Or is there something about the scenario I presented that makes it different, such as the fact that IRA distribution was all at year-end -- which @Opus 17 said doesn't eliminate the need for quarterly payments?  (Please consider my initial Social Security related question in the response.)  Thanks!

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As a threshold matter, I believe I have seen questions from other taxpayers who made the lump sum estimated tax payment and were still hit with an underpayment penalty.  So while the IRS instructions suggest this won't happen as long as you meet certain conditions, I am not convinced that only making a lump sum payment is enough.  There seems to be a different treatment of taxpayers who make quarterly estimated payments, and taxpayers who only make a payment in the 4th quarter.  Or, I am remembering the cases wrong.

One of the things the IRS says is that you will not be charged a penalty if you make enough estimated payments and withholding over the course of the year, to equal 90% of the current year tax bill or 100% of the previous year tax bill.  https://www.irs.gov/payments/underpayment-of-estimated-tax-by-individuals-penalty

So if we look at 2023, suppose your total income tax, no matter how it was calculated, was $10,000.  No matter what the tax in 2024 will be (based on your withdrawal and the effects on SS), you would be exempt from a penalty if you made 4 quarterly payments of $2500 (April 15, June 15, Sept 15, and Jan 15); or if you had $833 per month withheld from your SS benefit.  As long as you cover that 100% of last year figure, you should not owe a penalty.  But I still believe that must be met with periodic payments--I don't believe a $10,000 lump sum on January 15 will exempt you from the penalty, even though making 4 periodic payments would.  It's just something I think I've seen before on this board. 

Alternatively, you could try having $400 per month withheld from SS, and then pay the other $5200 as a lump sum with the IRA withdrawal. That would also cover it once you use the annualized method on form 2210, because the monthly withholding covers the requirement to pay something each month for the SS, and the lump sum covers the irregular income. 

Again, although I can't point to a specific person, I believe I have seen complaints here that indicate they were charged a penalty for lump sum income even when they made a payment.  I could be wrong.  My advice is conservative, pay something each month.  The opposite position, pay nothing until January 15 and then pay the minimum amount under the regulation (100% of last year's tax or 90% of this year's tax) is supported by some IRS documents, but those documents are sometimes incomplete.  

[fanfare]

If you look at the IRS Instructions and the flowchart on Form 2210 you will see that I am correct.

The rules of Form 2210 are implicit in the tax software even if the form is not attached to your filed tax return.

The two rules say nothing about how the withholding is parceled out on presumed or actual dates.

@Opus 17 

@bextel 

[rjs · Accepted solution]

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@Opus 17 wrote:

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@dmertz wrote:

Tax withholding is treated as paid evenly throughout the year while estimated taxes are treated as paid when actually paid.  By pay the tax via withholding from the IRA distribution, portions will be applied to earlier tax quarters.

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I believe this is only true if you use the annualized method on form 2210. 

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@Opus 17 

You do not need to use the annualized method in the situation that @dmertz suggested. As dmertz said, withholding is treated differently from estimated tax payments. All withholding is treated as if it was paid evenly over the course of the year, no matter when it was actually withheld. So a large amount withheld from a December IRA distribution is automatically spread over the year, and makes up for not having made estimated tax payments earlier. It's a built-in annualization, without having to fill out Form 2210 or Schedule AI. (I do this every year.)

A large amount of withholding in December is not a "lump sum estimated tax payment." It's a lump-sum withholding, and it's entirely different.

Anyone who was penalized in spite of a "lump-sum payment" either made an estimated tax payment instead of withholding, or still didn't pay enough in total even including the lump-sum withholding. Also note that the withholding has to be done in December (or earlier). You don't have until January 15 to withhold for the previous year.

[fanfare]

"Is this any different in the IRS's eyes than sending in an estimated tax payment for 90% of the year's tax in the last quarter "

Yes.

@bextel 

[Opus 17]

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@rjs wrote:

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@Opus 17 wrote:

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@dmertz wrote:

Tax withholding is treated as paid evenly throughout the year while estimated taxes are treated as paid when actually paid.  By pay the tax via withholding from the IRA distribution, portions will be applied to earlier tax quarters.

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I believe this is only true if you use the annualized method on form 2210. 

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@Opus 17 

You do not need to use the annualized method in the situation that @dmertz suggested. As dmertz said, withholding is treated differently from estimated tax payments. All withholding is treated as if it was paid evenly over the course of the year, no matter when it was actually withheld. So a large amount withheld from a December IRA distribution is automatically spread over the year, and makes up for not having made estimated tax payments earlier. It's a built-in annualization, without having to fill out Form 2210 or Schedule AI. (I do this every year.)

A large amount of withholding in December is not a "lump sum estimated tax payment." It's a lump-sum withholding, and it's entirely different.

Anyone who was penalized in spite of a "lump-sum payment" either made an estimated tax payment instead of withholding, or still didn't pay enough in total even including the lump-sum withholding. Also note that the withholding has to be done in December (or earlier). You don't have until January 15 to withhold for the previous year.

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Thank you, that is quite interesting and informative.

So as to the original question, if @bextel has withholding from their IRA withdrawal, that will avoid a penalty. But if they take the full amount and then make an estimated payment, they veer into penalty territory.  

[bextel]

Thanks much for all the explanations and advice.

Based on most responses (and a little web searching I’ve done based on those responses), it appears that by ensuring my December IRA distribution has withholding equal to at least 90% of my tax for the year, I don’t need to make quarterly estimated payments at all. Which eliminates the need to predict how much of my SS will end up taxable before knowing the ultimate IRA distribution amount. And could also explain why I’ve never been assessed an underpayment penalty since doing year-end IRA withdrawals and withholding, despite making no estimated quarterly payments (I only started taking SS late last year).

While I picked @rjs’s post as the Best Answer, numerous others were also quite helpful.