RMD – Fed Tax Withholding Question
This is likely to be a long post – please bear with me.
(Start rant) – I am completing my 2008 Fed Tax return. Because of “late-in-the-year” RMDs from IRA accounts, I have seriously underpaid this year’s tax burden, and, as a consequence, have begun to grapple with next year’s Estimated Tax Payment calculations. At this point, I am thoroughly convinced that the Tax Commissioner himself called the designer of the Estimated Tax Worksheet into his office and personally instructed him to develop a process that would discourage anyone from attempting to use the annualized method, and in the event anyone did try, to insure that the answers obtained from it would be so obtuse that no confidence could be ascribed to them. ( I have graduate degrees in Engineering and Computer Science with a major in Mathematics, and have never encountered a user interface as thoroughly bad as the ETW.) – (End rant).
Setting the Stage: I have significant income, other than IRA distributions, which are uniformly spread throughout the year. I would like to postpone all RMDs until late in the year (for tax deferral reasons). And I have the option to have Federal Tax withheld from the RMD(s).
My question to this forum is:
Is there a reference in the Tax Code which clarifies the options one has in claiming when the tax withheld from a IRA RMD should (can) be credited as payment? Ideally, this may be a way to satisfy the “pay-as-you-go” philosophy of the Tax Code while postponing actually paying the taxes as long as possible. I have found hints on the internet that indicate that RMD withholding amounts are considered by the IRS to be paid in four equal installments on the estimated tax due dates, but have not found one word confirming this in the Tax Code.
If this information is valid, then I pose the additional question as to whether one could eliminate all tax withholding from income throughout the year and use the year-end RMD withholding option to satisfy the quarterly estimated tax payments (with the proper calculations to make it all come out advantageously).
Any answers, facts or opinions are greatly welcomed.
Jim-theDIYguy
Permalink Submitted by Alan Spross on Tue, 2008-03-04 21:21
I think you are on the right track. Anything to avoid the annualized income worksheet. Late year withholding can make up for the lack of early year withholding
An RMD is NOT an eligible rollover distribution, so there is no mandatory withholding, but many custodians use a default 10% rate, and should be amenable to withholding whatever amount you request. It is true that withholding is allocated equally throughout the year, even if your distributions are not. Therefore, this challenge would be successfully resolved if you had enough withheld from the RMD such that your total withholding for the year from all sources at least equalled 100% of your total tax bill from the prior year (110% if AGI over 150,000), or 90% of your current tax bill or you owed less than $1,000 when you filed.
Permalink Submitted by Jim E WALLS on Wed, 2008-03-05 02:32
Thanks, you guys, for the quick replies and the thoughts. I have further consolidated my thoughts and now am planning along the following lines:
After talking with the IRS help line, I believe that the basic strategy outlined in this thread is sound. The IRS confirmed (I think) that withholding, at any time, from any source, is credited toward your tax liability. Also, if total of the amount withheld is 90% or more of your final tax liability, then no fees or penalties are levied.
With this information, I conclude that I was making it more difficult than necessary in trying to defer tax by paying estimated quarterly amounts – one just needs to arrange to have enough withheld in one lump sum near the end of the year to cover at least 90% of the final tax liability. This also gives another three months deferral for the other 10%.
In the month of December, almost all taxpayers should be able to accurately calculate how much total tax is due for that year. Then having 90% of that amount withheld from the year-end RMD is a lot (and I mean a LOT) simpler than trying to use the Annualized Estimated Tax Calculation Worksheet.
I am going to employ this strategy to convert some of my IRA funds into ROTH accounts early in the year. I know what my RMD is for 2008. Using this amount as 90% of the tax I can pay this year, I will then calculate backwards to see how much AGI I can produce without exceeding the 25% tax bracket; then, subtracting my (predictable) fixed incomes for the year, I can arrive at an amount to convert to ROTH. Come the end of the year, I can elect to have the entire RMD paid to the IRS as withholding. Of course this will leave 10% of the tax to raise from savings during the first quarter of 2009. (In 2009, I won’t have this problem because the Bush “tax cuts” permit/allow conversion of IRA to ROTH with the benefit of a two year tax deferral.)
Does anyone have see a fatal flaw in this plan?
Jim-theDIYguy
Permalink Submitted by Alan Spross on Wed, 2008-03-05 02:58
Yes, the Roth conversions do introduce a glitch.
Even though you do them by direct transfer, they are still considered first a distribution and a rollover to the Roth. That in turn triggers the requirement that your first TIRA distribution is deemed to be your RMD, which is NOT rollover eligible.
Therefore, if you wish to do a Roth conversion, you must take your RMD first. You could do them a day apart and either early or late in the year as long as the RMD is taken first. You should also avoid withholding from your Roth conversion distribution from the TIRA, although I don’t think you were planning that.
If you find that figuring 90% of your current year taxes requires too much guesswork, it’s easier to just use 100% (unless 110% applies due to AGI) of your prior year tax liability, since that takes no calculation or assumptions whatsoever. If you have other periodic payments coming in such as a pension or SS, they can also be sources of withholding. Several pension administrators allow you to alter your withholding by a simple phone call and/or make a one time December withholding election. So you still have many ways to avoid the estimates or miserable calcs.
Finally, the first year for the no income limit Roth conversions and also the year for two year tax deferral is 2010, not 2009. And remember, for various reasons you can always recharacterize a Roth conversion, either totally or partially as late as 10/15 following the year of conversion. That will retroactively reduce your tax liability.
Permalink Submitted by Jim E WALLS on Wed, 2008-03-05 21:35
alan & others:
Thanks again for the info magically materializing here!
I was unaware of the provision that the first distribution for an IRA-type account had to be accounted as (part of) the RMD. This puts a kink in my plans, but, since I have two IRAs, I can still rollover as much as the math allows into a ROTH from one and pay the resultant tax later in the year from the RMD on the other.
BTW, I was cognizant of the 2010 change in ROTH conversion rules – that’s what happens when I am typing one thing and thinking about another. But that does bring up another dilemma for me – what t do about next year’s planning so far as partial ROTH conversions and the tax consequences are apropos. But that’s for another thread, I suppose.
Thanks again
Jim-the DIYguy
Permalink Submitted by Alan Spross on Thu, 2008-03-06 00:22
There is still a problem with doing the conversion first. A distribution from ANY of your IRAs, no matter how many you have is credited first to your RMD for any of them. Therefore, the total RMD must be distributed before doing a conversion. This rule is due to IRA aggregation rules which states that the RMD can come from any of the various IRA accounts in any combination you wish. Of course, this timing problem does not surface until RMDs must start at 70.5.
The net result is that either your conversion must be done later than you would like or your RMD must be taken earlier, or some compromise is reached. For example, you could make both the transactions in the middle of the year.
If you want to cover your withholding from your RMD, that means that you must estimate how much your conversion is going to add to your taxes. What this all means is that if you want more time for the Roth conversion to develop earnings, that means that the less time for your RMD to remain tax deferred and more time for the IRS to hold the tax withheld. One possible compromise – if your conversion is larger than your RMD, do them both earlier, but if your RMD is larger, do them later in the year. That at least leverages the time value of money in your favor given these restrictions.
Permalink Submitted by Jim E WALLS on Thu, 2008-03-06 03:07
alan: Shucks! I was just about to put a period to the planning phase of my conversion plan and start the implementation. Your last post puts a big monkey wrench in that approach! (‘:roll:’) Looks as if the best strategy now is to fall back to estimated quarterly payments. (‘:?’)
Maybe I can rationalize my risks in the following manner:
In the context of the present discussion, it is almost always best to defer taxes as long as possible, but
No one can convincingly predict the near-term performance of the market, so
If I take my total RMD from all accounts early (like now) and simultaneously rollover to ROTH as much of the remainder as tax calculation shows is feasible, then, just maybe, I am actually hedging the market as per the following reasoning.
The market is very likely to go up, or go down or to remain the same. If it goes up, then I have lost the “profit” on the RMD inside a tax-deferred account, but I have gained profit, within a tax-free environment, from the wealth transferred to the ROTH.
If the market goes down, then I have presciently “cashed-out” my RMD ahead of the downturn (and hopefully, have invested it in a recession-resistant money market. Also I will be able to pay my taxes with wealth which would have evaporated if left inside the 401k in a down market). At the same time, the funds inside the ROTH are no worse off than they would have been if left in the 401k.
If the market sort of drifts along, then the RMD wouldn’t have “made” any money in the 401k anyway, and the ROTH investment is in the best investment vehicle for the future.
BTW – I have read pub 575 (pg 31 and 32) and can not find any wording that would suggest either that the RMD must be represented in the first distribution, or that a distribution from any tax-deferred account must account for all aggregated RMDs. Could you point me to such reference? Thanks.
Obviously, I’m not going to act on this until things clear up a bit.
Jim-the DIYguy
Permalink Submitted by Alan Spross on Thu, 2008-03-06 05:07
Since you are dealing only with IRA accounts, you should be using Pub 590, not 575. However, p 26 of Pub 575 does indicate that an eligible rollover distribution does not include an RMD. See “Eligible Rollover distribution, #2.
The companion wording in Pub 590 is the first paragraph on p 26. The clarification that a Roth conversion constitutes a rollover is on p 29, “Allowable conversions”. This clearly identifies the Roth conversion as a distribution followed by a rollover to the Roth account.
The Publications are of course IRS written summaries of the tax code and tax regulations. Following is a pasted copy from the IRS Regs:
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Sec. 1.401(a)(9)-7 Rollovers and transfers
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Q–1. If an amount is distributed by one plan (distributing plan) and is rolled over to another plan, is the required minimum distribution under the distributing plan affected by the rollover?
A–1. No, if an amount is distributed by one plan and is rolled over to another plan, the amount distributed is still treated as a distribution by the distributing plan for purposes of section 401(a)(9), notwithstanding the rollover. See A–1 of §1.402(c)–2 for the definition of a rollover and A–7 of §1.402(c)–2 for rules for determining the portion of any distribution that is not eligible for rollover because it is a required minimum distribution.
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Here’s more from 1.402(c)-2:
Q–7: When is a distribution from a plan a required minimum distribution under section 401(a)(9)?
A–7: (a) General rule. Except as provided in paragraphs (b) and (c) of this Q&A, if a minimum distribution is required for a calendar year, the amounts distributed during that calendar year are treated as required minimum distributions under section 401(a)(9), to the extent that the total required minimum distribution under section 401(a)(9) for the calendar year has not been satisfied. Accordingly, these amounts are not eligible rollover distributions. For example, if an employee is required under section 401(a)(9) to receive a required minimum distribution for a calendar year of $5,000 and the employee receives a total of $7,200 in that year, the first $5,000 distributed will be treated as the required minimum distribution and will not be an eligible rollover distribution and the remaining $2,200 will be an eligible rollover distribution if it otherwise qualifies. If the total section 401(a)(9) required minimum distribution for a calendar year is not distributed in that calendar year (e.g., when the distribution for the calendar year in which the employee reaches age 701/2 is made on the following April 1), the amount that was required but not distributed is added to the amount required to be distributed for the next calendar year in determining the portion of any distribution in the next calendar year that is a required minimum distribution.
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Finally, here are the Regs clarifying that an IRA account under Sec 408 is subject to the same RMD rules as shown in 1.401a:
Sec. 1.408-8 Distribution requirements for individual retirement plans
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The following questions and answers relate to the distribution rules for IRAs provided in sections 408(a)(6) and 408(b)(3).
Q–1. Is an IRA subject to the distribution rules provided in section 401(a)(9) for qualified plans?
A–1. (a) Yes, an IRA is subject to the required minimum distribution rules provided in section 401(a)(9). In order to satisfy section 401(a)(9) for purposes of determining required minimum distributions for calendar years beginning on or after January 1, 2003, the rules of §§1.401(a)(9)–1 through 1.401(a)(9)–9 and 1.401(a)(9)–6 for defined contribution plans must be applied, except as otherwise provided in this section. For example, whether the 5-year rule or the life expectancy rule applies to distributions after death occurring before the IRA owner’s required beginning date is determined in accordance with §1.401(a)(9)–3 and the rules of §1.401(a)(9)–4 apply for purposes of determining an IRA owner’s designated beneficiary. Similarly, the amount of the minimum distribution required for each calendar year from an individual account is determined in accordance with §1.401(a)(9)–5. For purposes of this section, the term IRA means an individual retirement account or annuity described in section 408(a) or (b). The IRA owner is the individual for whom an IRA is originally established by contributions for the benefit of that individual and that individual’s beneficiaries.
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