3676 / What should taxpayers consider when determining their withholding for an IRA? Are taxpayers required to make estimated payments with respect to IRA distributions?

Taxpayers with IRA investments will face mandatory distributions (RMDs) from IRAs beginning April 1 of the year after the year the individual reaches age 73 (72 for 2020-2022, 70½ prior to 2020). For those who have focused on accumulating retirement savings in traditional IRAs, this means that taxes will be due on all distributions at the individual’s ordinary income tax rate. Each taxpayer has options when it comes to how those taxes will be paid, however. The individual may choose to make estimated income tax payments, which are due by April 15, June 15,
September 15 and January 15 each year, or the account owner can choose to have his or her IRA custodian withhold taxes from each distribution (similarly to how the employer withholds from an employee paycheck).

If the taxpayer chooses withholding, he or she does not have to determine the proper level of estimated payments, but should continue to calculate anticipated income each year in order to avoid under or over-withholding. The taxpayer is able to specify the exact percentage that he or she wishes to be withheld from each distribution, so the risk remains that the taxpayer will over or under pay throughout the year. Further, the IRS will assume that the amount withheld by the taxpayer was paid in equal installments over the year, but the taxpayer is able to make a single lump sum payment if advantageous. Taxpayers are also able to have a certain percentage withheld from each IRA distribution, but also make estimated payments in order to avoid the year-end tax hit.

When an account owner converts traditional IRA funds to a Roth account, he or she is again liable for ordinary income tax on the amount converted. The taxpayer has the option of specifying the amount that should be withheld from the conversion (because each individual will have to anticipate income from other sources in order to determine his or her tax liability for the year). If the taxpayer fails to specify the percentage that should be withheld from the converted amount, the IRA custodian will withhold 10 percent as a default.

Unfortunately, for taxpayers who convert to Roth accounts, the amount that is withdrawn to cover the amount that must be withheld will also be subject to tax—at ordinary income tax rates. This requires the taxpayer to take this into consideration when determining the withholding amount, which can be complex. In the case of a Roth conversion, therefore, it is generally in the taxpayer’s best interest to pay their tax liability on the distribution using funds outside of the IRA—potentially making the estimated payment route the more attractive option.