Regardless why, you’ve decided to withdraw money from your IRA. Therefore, you need to know what tax liability (if any) you’re responsible for and if you need to make estimated tax payments. If you don’t pay estimated taxes, you may face an underpayment penalty. Paying estimated tax for IRA withdrawals is not uncommon. You need to consider several factors including income level, age, and what type of IRA you own. First, let’s look at how estimated taxes affect the individual who has a traditional IRA.
Estimated Tax and Withholding for a Traditional IRA
Unless someone elects explicitly to waive withholding for traditional IRA distributions, money withdrawn from the IRA will be subject to federal withholding of ten percent. The process is automatic and takes the worry out of paying what you owe Uncle Sam.
You can opt out of withholding by filling out form W-4P or have any amount over ten percent (up to 100% ) withheld. Use this form to change or make a withholding election any time you take a distribution. It also applies to all future distributions unless it’s modified or revoked. Although it seems that estimated tax payments won’t be an issue when your financial institution withholds taxes – that’s not always true, as we will see later.
Withholding is also applied differently when the distribution is made from an annuitized IRA. In this case, the IRS treats withholdings as if the distributions are wages. You can also elect out of withholding on annuitized IRA distributions.
Sadly, many taxpayers equate this withholding with the amount of tax they owe, but, it rarely works out that way. Just because a financial institution withheld 10% from your IRA distribution, doesn’t mean that that’s the amount due in taxes. It’s possible that you owe no more than that, but depending on your situation, it could also be (very) much more.
Merely withholding ten percent of an IRA distribution to satisfy your federal tax liability could still result in you owing a significant amount to federal and state governments come tax time. Also, do not forget that state tax laws vary; check with a tax professional to find out what rules apply in your state.
Traditional IRA and Estimated Tax for IRA Withdrawals
If you’ve decided to waive automatic withholding from your traditional IRA distribution, you may need to make estimated tax payments. Visit the IRS website and download form 1040ES. You will find out who needs to pay estimated tax, how much you may need to pay, and you will also have payment vouchers and the address where your payment needs to go.
The Difference Between a Roth and Traditional IRA
While your money will grow tax-free in both types of IRAs; the IRS levies taxes on a traditional IRA when you withdraw your retirement money. On the other hand, the Roth IRA is the opposite. An excellent feature of Roth IRAs is that when the time comes, retirement money can be withdrawn free from income tax.
Although, there are income restrictions based on your modified adjusted gross income (MAGI) on who can contribute to a Roth IRA.
For 2018, if you are:
- Single and earn less than $135,000
- Married filing separately (living with your spouse) and making less than $10,000
- Married filing separately (not living with your spouse)and earn less than $135,000
- If Married filing joint earning less than $199,000
- Head of household making less than $135,000
Then, a Roth IRA is an option you can explore. Realize there is still a penalty for early withdrawal (before age 59 ½) and aside from specific circumstances.
Estimated Taxes and Withholding If You Have a Roth IRA
Any contributions made to a traditional IRA are tax-deductible on both state and federal tax returns. Consequently, the IRS taxes any withdrawals at regular income tax rates. The Roth IRA is different; while providing no tax break for contributions, the earnings and withdrawals will be tax-free. However, estimated tax payments can be an issue in the tax year that you convert a traditional IRA to a Roth.
Estimated Tax and a Backdoor Roth IRA Conversion
A backdoor Roth IRA is when you convert a traditional IRA into a Roth IRA. In a conversion, you’ll have to pay income tax on the contributions. The IRS will apply that amount to your total income. Furthermore, the regular income tax rate will apply. A sufficiently large conversion could potentially change your income bracket. Moreover, it can severely affect the amount you owe in both federal and state taxes (depending on the state) for the year you perform the conversion. Seek professional tax advice to find out whether you have to pay federal and state estimated taxes (and how much).
There is some good news; if you paid taxes on your traditional IRA contributions (you didn’t take the deduction), then you may not owe income tax after converting it to a Roth.
The 5-Year Rule
The 5-year rule means that owners of a Roth IRA must have kept assets in the Roth account for at least five years to take tax and penalty-free withdrawals from it. The trick is that two five-year rules exist. One rule applies to money directly contributed to a Roth account, while another pertains to assets in a Roth account that was converted to a Roth from a traditional IRA.
The Rule for Money Directly Contributed to a Roth
When someone contributes money directly to a Roth IRA, the five-year clock starts ticking from the first day of that tax year when you begin funding the Roth. If you meet any of the other requirements:
- Over 59 ½ years old
- A first-time home buyer
You should be able to start making tax and penalty-free withdrawals five years later with no withdrawal-related estimated tax issues.
If You Converted from Traditional to Roth
It is when the benefit of converting to a Roth shows.
With assets that you’ve converted to a Roth, instead of contributed directly; there is no tax liability because you already paid income tax on that money when you moved to a Roth. But, you may still be subject to a ten percent penalty if you withdraw the converted assets before age 59 ½ or before five years have passed from the date of conversion.