Roth conversion tax
My current pension and SocSec tax withholding meets my current year tax obligations.
If in November I then decide to do a significant Roth conversion, assuming my tax obligation is an additional $15,000, will it be OK just to make an online tax payment (federal and state) at the time of the conversion?
Doesn’t the government assume my income, including now the Roth conversion, occurred over the course of the entire year and I should’ve been making associated tax payments all year long? And perhaps result in some type of penalty?
Permalink Submitted by David Mertz on Mon, 2021-02-01 19:06
With regard to figuring underpayment penalties, the default is to treat your income as received uniformly throughout the year. However, you have the option to annualize income on Schedule AI of Form 2210, allowing the income to be treated as taxable when received instead of being taxable in approximately equal parts in each tax quarter of the year.
Preparing Schedule AI is rather onerous, so it is far easier to pay all of your ultimate tax obligation in equal parts throughout the year, but if you find that in earlier quarters you underestimated your ultimate tax liability and did not pay enough in earlier quarters to avoid a penalty for tax quarters prior to the one in which you received a large portion of your taxable income, annualizing will reduce or eliminate the penalty.
Permalink Submitted by Alan - IRA critic on Mon, 2021-02-01 19:14
Since you pay via withholding, there will be no underpayment penalty if the amount withheld meets a safe harbor of 100% of your 2020 tax liability (110% if 2020 AGI over 150k). There is another safe harbor of 90% of your 2021 tax liability, but since your conversion amount is “significant” you likely would not use the safe harbor based on 2021 taxes. Just adjust withholding to meet the applicable % of your 2020 tax liability, once you determine that.
While meeting the safe harbor eliminates an underpayment penalty, you could still incur a sizeable tax due amount in April, 2022.
When you pay using withholding, you are treated as having paid equally throughout the year even if all the withholding is near year end. However, your pension may not allow frequent withholding changes if you need to increase WH and later reduce it back to normal. While the date you pay does matter if you are paying with quarterly estimates, it does not matter with withholding.
If this is a one time large conversion, you would probably use the 90% of current year tax liability in 2022 since 100%/110% of your 2021 tax liability would probably be too high. This change of safe harbor methods occurs whenever your tax liability drops a large amount from the prior year, as may occur for you in 2022.
If you did incur a penalty, the interest rate is currently only 3% of the shortfall, so a small underpayment is not a big deal.