By Andy Ives, CFP®, AIF®
A “life hack” is any trick, shortcut or simple and clever technique for accomplishing a familiar task more easily and efficiently, in all walks of life. For example, tie a colorful ribbon to your luggage to make it more easily identifiable on the airport conveyor belt. Life hack! Make ice cubes out of coffee so as to not water down your iced latte. Or, turn on your car’s seat warmer to keep the take-out pizza hot on the trip home. Life hack!
Life hacks can also be found in the financial world.
Many taxpayers need to make estimated tax payments. Generally, taxpayers should make these payments in four equal amounts throughout the year. (April 15, June 15, September 15, and January 15 of the following year.) If you fail to pay enough tax, or if your payment is late, you may be charged a penalty. Did you take a large capital gain late in the year? Did you earn more income than expected? Uh, oh. These could cause an estimated tax problem.
Believe it or not, there is a basic “life hack” for anyone who may have underpaid their Federal estimated taxes: Leverage the federal withholding option on an IRA withdrawal!
If it is discovered that previous estimated tax payments were not enough to cover income for the year, a taxpayer could take a distribution from his IRA. The IRA owner could elect to have up to 100% withheld for taxes. This tax withholding will be treated as if it were paid in evenly throughout the year, across all quarterly payments, even if the withholding tax was taken from a distribution on December 31st. Life hack! (Note that if the IRA owner is under age 59 ½ and no other exception applies, there will be a 10% early distribution penalty, even if 100% of the distribution is withheld for taxes.)
But what to do about the missing IRA dollars that were sent to the IRS? If the IRA distribution is eligible for rollover, the IRA owner can replace those IRA dollars with a 60-day rollover. But weren’t the IRA dollars sent to the IRS? How can they be rolled over?
We don’t rollover the exact same dollars. We replace the dollars sent to the IRS with non-IRA funds from a savings or checking account (or some other source). As long as you complete the rollover within 60 days, and as long as the IRA owner has not done another 60-day rollover within the previous twelve months, this strategy will allow the IRA to be made whole.
Had we attempted to make up the difference of underpaid estimated taxes with a single payment directly from a non-qualified account (like a checking account), the payment would have all counted for the fourth quarter, potentially resulting in an estimated tax penalty. By leveraging the Federal tax withholding option on an IRA withdrawal, those payments are smoothed out and deemed to have been paid in evenly over the year. Additionally, by following the 60-day rollover guidelines, we can replace the IRA dollars sent to the IRS. The net result is timely paid estimated tax payments and a fully funded IRA.