Paying Tax on Previous Year IRA Withdrawal
I have a situation in which an underpayment of federal and state taxes were paid for a normal IRA distribution taken during last year. With the goal of avoiding paying taxes on another distribution to cover a previous year’s tax, can I make a distribution request specifying an amount to be withdrawn and designating the tax year to apply the amount to. Alternatively, to avoid possible IRS reporting confusion, can I authorize the IRS to automatically withdraw an amount from my IRA account and apply it to the previous year’s tax owed? What distribution codes, if any, apply and what forms would be used?
Permalink Submitted by Alan Spross on Wed, 2011-05-04 20:24
You could ask your IRA custodian, but I do not believe that you can take an IRA distribution for withholding for a prior year. Even if the custodian could do it, you would still owe the taxes for this year because the distribution is for this year. Further, if you are under 59.5, you would incur a 10% penalty on the distribution even if it was all allocated to tax withholding.
While the IRS has authority to put a tax lien on your IRA, this is not something they do at your request. An official tax lien distribution to the IRS is exempt from the early distribution penalty, so the IRS will not want to provide this service to help you avoid the penalty.
At this point, if your only income source to pay 2010 taxes is your IRA, you will have to simply take a distribution large enough to pay the taxes, and if you are also concerned about this year’s taxes, you would have to gross up the distribution to have 2011 taxes withheld in addition to the amount you need to withdraw for the 2010 taxes. The gross amount is even higher if you will owe the 10% penalty.
The only benefit of using your IRA to pay taxes that I can think of is if you are behind on your quarterly estimates, you can take an IRA distribution late in the year and have a high % withheld. Withhholding is deemed paid equally throughout the year, so this could help you reduce the shortfall in earlier quarters and thereby reduce the underpayment penalty. But even doing that, you have to factor in the additional tax bill on the distribution used for withholding, and a 10% penalty on it if you are under 59.5 or do not have a different penalty exemption to use.
Permalink Submitted by Alan Hingeveld on Wed, 2011-05-04 21:48
Following your point that it would be necessary to take a distribution large enough to pay the previous underpayment of taxes, and then have additional taxes withheld to cover this new distribution this year, aren’t you being taxed twice for that original distribution that was made in a previous year (this would not have been the case if the tax had properly been added into the original distribution)? And what about the case of the State portion? Are there any provisions for deducting that on the Federal tax forms?
Permalink Submitted by Alan Spross on Wed, 2011-05-04 23:18
No, you are not being taxed twice on the total, but you are taxed twice on this year’s distribution because you did not yet pay the taxes on last year’s. Assume you in the 25% bracket and took out 40k last year:
1) You owe 10k in taxes for 2010 that you did not pay
2) You must gross up the 10k (10/100-25) = 13,333 and take out 13,333 this year. From the 13,333 you pay the 10k tax from last year and 3,333 for this year’s taxes.
In total, you took out 40k plus 13,333 for a total of 53,333 on which you owe 25% or 13,333. And that is the amount you paid to the IRS.
And it is worse if you factor in the 10% penalty if you owe it. You would then have to re figure the above using 35% as your marginal rate. That would increase your distribution this year to 21,538 in order to pay the added penalty.
With respect to the state income taxes which I included in the 25% or 35% figure above, if you can itemize deductions on your federal return you can itemize the state income tax you actually paid during the year. But this is complex because you also have the option to claim sales taxes instead of state income taxes if they are higher, so you would have to figure which is higher. Also, if you happen to fall under the AMT, you effectively lose both these deductions when figuring the AMT tax. You probably know if you fall under the AMT or not. It is more likely if you have alot of deductions and dependents and live in a high tax state such as many of the northeastern states or CA.