Thursday, December 26, 2013

Use your IRA to avoid a 2013 tax penalty

Jeffrey Levine for MarketWatch writes: Generally speaking, if you're generating income from earnings, investments or other sources, you should be paying tax on that income throughout the year. If not, you could be subject to estimated tax penalties.

To avoid an estimated tax penalty for 2013, you've had a few options. One way you could have been avoiding such a penalty is by paying in 90% of your 2013 tax liability through quarterly payments. While that's a perfectly acceptable method of avoiding an estimated tax penalty, it has one big drawback: It's not always so easy to figure out your tax liability for the year early on. Any unexpected changes in your income, deductions, credits, exemptions, etc. could have a significant effect on your 2013 tax liability.
The second way you could have been avoiding an estimated tax penalty in 2013 is paying in 100% of your 2012 tax liability (110% if your 2012 AGI was greater than $150,000) through quarterly payments. Assuming you've been using either of these methods, you won't owe any estimated tax penalties for 2013, no matter how much additional tax you may owe after filing your return.
For example, suppose you paid $10,000 in tax for 2012 and then, in January 2013, you won $100 million in the lottery (in which case, you really should be paying someone else to read this article for you!). So long as you've been making 2013 quarterly estimated tax payments of $2,500, and timely make your last quarterly estimate by January 15, 2014, you won't have any estimated tax penalty for 2013. You will, of course, still have a hefty tax bill to pay by April 15, 2014.
Now you might be asking yourself, "Where does the tax I've had directly withheld fit into all of this? Isn't that another way I pay tax throughout the year and, if so, can't that help me avoid an estimated tax penalty?" The answer is an emphatic "yes," but it gets even better than that.
As a general rule, any tax withheld is treated as if it is paid in evenly throughout the year, regardless of when it is actually paid to Uncle Sam. Once paid in, withholding effectively acts as estimated tax payments and can decrease, and in some cases eliminate altogether, any estimated tax payments you would otherwise have to make. So, for instance, if you have $10,000 withheld from your December paycheck, pension or other withholding-eligible-source-of-income for federal income taxes, it's still generally treated as though you paid in $2,500 per quarter.
But suppose you haven't been withholding enough taxes so far this year and/or you haven't been making the proper quarterly estimated payments in 2013. Does that mean that you're going to have a penalty? Probably...unless you do something to fix the problem before the end of the year. Given the fact that we're now only about a week away from that deadline, there's generally not much you can do at this point.
Thankfully, however, if you happen to have an IRA, you can take advantage of a nifty trick to reduce, or even eliminate, any estimated tax penalties you might otherwise owe. Here is a step-by-step guide on how to do so:
Step 1: Calculate the amount of tax you should have paid in earlier in 2013, but did not. Remember, you can use 100% of your 2012 tax liability (110% if 2012 AGI was more than $150,000) as a safe-harbor total.
Step 2: Contact your IRA custodian or financial adviser and find out what the distribution procedures are for your IRA. Some of the questions you might consider asking are "What paperwork is needed in order to process my distribution?" and "By what date do you need to receive my paperwork in order to make sure my distribution is processed in 2013?" Chances are they may need the paperwork in before December 31st to process the payment by that date.
Step 3: Request a distribution from your IRA for the amount of the shortfall you calculated in step 1. Look for the section on your IRA distribution form that covers federal withholding and withhold 100% of your IRA distribution for federal taxes. Doing so will treat your IRA distribution as if it had been paid to Uncle Sam ratably throughout 2013.
Step 4: Within 60 days of your distribution, replace the money distributed from your IRA with non-retirement account money. This completes a rollover and keeps your distribution from being taxable. If you end up withholding more than you needed to, don't worry. You'll get any excess back when you file your tax return. Be careful, though: If you made an IRA-to-IRA rollover into or out of this account in the last 365 days, you'll have to take additional steps to avoid running afoul of the once-per-year IRA rollover rule.  
If you follow these steps precisely and in a timely manner, you will avoid owing any taxes on your IRA money sent to the IRS for withholding and you will completely eliminate any 2013 estimated tax penalty you would have otherwise owed. 


Post a Comment