Paying the Taxes on a conversion
I’ve not heard anyone talk about this so I wanted to toss it out there for discussion.
If someone converts an IRA to a Roth in 2010 and decides to pay the taxes in 2011 and 2012, would this work…
Significantly increase withholding’s at work on Jan 1 2010. When filing 2010 tax return in April 2011, they qualify for a huge refund. Instead of taking the refund, they apply it to 2011. Then, continue to “over-withhold” for all of 2011 and 2012.
Net effect.. Pay the taxes out of cash-flow over a three year period.
Would this work? Are there any employer issue I need to know about?
Thanks.
Tony
Permalink Submitted by Alan Spross on Fri, 2009-12-04 16:39
It would work, but would be a cash flow killer, giving the IRS an interest free loan. However, it may help avoid the need to supplement 2011 and 2012 withholding by paying in quarterly estimates. If they recharacterize the conversion, they can then accept the tax refund.
It also provides timely partial tax payments in the event the person decides to opt out of the deferral and report the entire conversion in 2010 for some reason.
There should be no employer issues here as long as they provide the proper withholding form to the HR Dept.
If interest rates increase next year, the cost of the tax free loan goes up. In that case, they would be better off to eliminate the withholding and put the tax money in a CD or savings account, collect the interest, and then withdraw it to pay quarterly estimates starting in 2011.
Permalink Submitted by Tony Pondel on Fri, 2009-12-04 16:43
Thanks for the quick reply. So we should anticipate a need to make quarterly payments? I have not heard anyone mention that before either.
Permalink Submitted by Alan Spross on Fri, 2009-12-04 17:15
It depends on how large the conversion is relative to the salary income. In some cases, added withholding would be sufficient, but if the conversion is large enough that quarterly payments would be needed to supplement the withholding, then perhaps the entire conversion bill should be handled by estimates. But any combination of the two is fine with the IRS as long as the money comes in on a timely basis.
One key element is that withholding is considered paid equally over the entire year even if it was all taken out in December, whereas quarterly estimates are only credited when they are actually paid. So you can make up lost time with withholding from a salary or pension, but you cannot make up past quarterly deficiencies solely by upping current estimates.
I assume the IRS will consider a 2010 conversion as done 50% in the first quarter of 2011 and 50% in the first quarter of 2012, rather than being spread over all the quarters. But the iRS cannot charge interest if the taxpayer meets a safe harbor, ie paying in 100% of the prior year’s tax liability (110% for higher incomes) in withholding or timely estimates, no matter how much additional will be due in April.
The main issue is whether the taxpayer just wants to avoid underpayment penalties no matter how much they may owe in April, or they want to set it up so that they do not owe much of anything when the return is filed.