How to avoid automatic tax withholding on RMD, pay with taxable funds

Submitted by Ron Smith on Mon, 2015-11-16 02:06

I understand that it is best to pay taxes on distributions from pre-tax investments (IRA, 457, 401k, 403b, etc.) with funds that have already been taxed.

Does that apply to RMD as well? Should the related taxes be paid with after tax funds?

If so, how can automatic withholding taxes be avoided during the RMD transfer? Then, how would the tax payment be made?

Thank you!



Submitted by Alan - IRA critic on Mon, 2015-11-16 03:38

There is no method that is best for everyone.  If withholding is taken from retirement plan distributions, quarterly estimates can usually be avoided. Since withholding will be credited toward your total tax bill, it does not matter whether the source of the withholding is taxable or not. The default withholding (if you do not make an election) on IRA distributions is 10%, and for qualified plans is 20%, but not for RMDs since the 20% mandatory withholding only applies to distributions eligible for rollover. RMDs cannot be rolled over. For an IRA, you can usually elect any % you want or decline withholding altogether. Therefore, there is plenty of flexibility to pay your taxes as you wish.

Submitted by Ron Smith on Mon, 2015-11-16 11:20

THank you for your response, Alan! For clarification,

  • Will submission of a completed copy of a W4P-2015 form be sufficient to decline withholding on an RMD?   
  • How about a ROTH rollover? 
  • In either case, if the automatic withholding can be avoided, then can the taxes then be paid (with after-tax funds) by using a quarterly estimate tax payment?

 Thank you!

Submitted by Alan - IRA critic on Mon, 2015-11-16 15:41

  • Requirements vary with the custodian, but to decline withholding on an IRA distribution you probably will be allowed to specify that when you request the distribution, with no form required.
  • A Roth conversion, which can only be done in an RMD year AFTER the RMD has been completely satisfied, generally should have withholding declined. Unlike an RMD, a conversion is a rollover and if you have withholding taken out, your Roth conversion will be less than the distribution and you would have to come up with other funds to make the Roth IRA whole within 60 days. Some exceptions apply to the declined withholding advice when there is a specific strategy.
  • Yes, if withholding is declined on retirement plan distributions, the expected tax bill must be addressed by other withholding sources or more likely quarterly estimates.
  • In summary, withholding should be considered for RMDs, but probably not for the distribution for a Roth conversion.

Submitted by Ron Smith on Mon, 2015-11-16 18:30

Thank you for your time and patience, Alan.  I complicated things by combining w/h on both an RMD and a ROTH conversion.  Should have kept them separate.  Let me respond to your post as if your bullets were numbered 1 through 4 to ensure I understand: 

  1. IRA distribution: usually no form required to decline tax w/h.  (Is that true of 457 & 401k plans?)
  2. (Post RMD) ROTH conversion options with w/h taxes:
  1. generally should have w/h declined OR
  2. otherwise it is possible to make the ROTH IRA “whole” by depositing “other” funds.  
  1. transfer to the ROTH IRA from a checking a/c?  
  2. Would it be wise to use funds from a taxable investment account?
  • It is really good to know that the tax bill could be handled via an estimated tax payment rather than w/h.
  • I am confused here.  Does “w/h should be considered for RMDs, but probably not for the distribution for a ROTH conversion” mean:
    1. decline withholding for RMD, but not for a distribution for a ROTH conversion (making ROTH whole with taxed funds) OR
    2. use automatic withholding for RMD, but decline withholding for a distribution for a ROTH conversion?

    Again, Alan, your time and patience are much appreciated.Best regards,Ron

    Submitted by Alan - IRA critic on Mon, 2015-11-16 19:49

    1. Either plan may not require any form, just a % or a dollar amount. IRAs are more likely not to need any form, but 401k or 457b may require a their own form or perhaps a W4 P.
    2. a is preferable, but it you still want to have withholding taken, the amount withheld can be rolled to the Roth to complete the conversion within 60 days. This amount can come from any source, usuall checking but also a check from a brokerage account would be fine.
    3. The advantage of withholding is that it is deemed to be paid equally throughout the year even if you do not take the distribution until December. Estimates are credited only when actually paid, so you cannot eliminate a quarterly shortfall by higher estimates later. Withholding avoids that problem. Of course, many people use a combination of both even though it may be simpler to use just one or the other.
    4. b. The RMD cannot be rolled over so using withholding does not cause any other problems. If you withhold from a conversion distribution however, you need to replace the withholding by contributing other money to the Roth IRA to complete the rollover. If you are doing both an RMD and a conversion as separate distributions (RMD must be done first), I would withhold enough from the RMD distribution to eliminate the need to withhold anything from the conversion. But that may not be possible if you are doing a large conversion relative to your RMD amount. You can usally withhold up to 100% if you want to though from the RMD. With all this flexibility available, people use many different combinations to pay their taxes. There is one single best method for everyone. I take my own RMDs in December and withhold an amount equal to last year’s tax liability and that eliminates quarterly estimates.

    Submitted by Ron Smith on Thu, 2015-11-19 12:50

    Thank you, Alan, helping me understand this.  It is great that you have the gift of teaching.  (To point 3 & 4) While I see the advantage of having taxes withheld from an RMD or a ROTH conversion to avoid quarterly estimates, I keep hearing the counsel to NOT pay taxes with pre-tax funds:  

    1. Please address whether it is preferrable to pay taxes with after-tax dollars, rather than pre-tax dollars,
    2. And then explain the best way to pay with after-tax dollars, if that is preferrable.  For example, would it work to pay the estimated taxes (for RMD and/or conversion) quarterly throughout the year rather than waiting to pay the taxes with the quarterly estimate AFTER the transaction(s) have been made.

     

    Submitted by [email protected] on Fri, 2015-11-20 22:46

    Since RMDs are not rollover eligible, which means not conversion eligible either, consider the RMD to be equivalent to after-tax dollars once taken.  So, since you need to take your RMDs first, you could take them and deposit them into your checking account.  Now they are after-tax. They would then be able to be used to pay the taxes due on the RMD distribution plus some/all of the tax liability of the conversion that follows.  OR, you could tell the custodian to withhold 100% (some custodians only allow up to 99%) of the RMD, which will now count toward your tax liability as Alan says above.  Followed by the conversion with no withholding.  Then, if additional taxes are due on the conversion, you would prefer to use after-tax existing sums (from your checking account for example) to pay the tax at filing time, or if you don’t have anymore after-tax dollars, consider withholding some of the conversion amount. 

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