Individuals receiving distributions from pension plans, IRAs, and other retirement accounts can be affected if their withholding amounts fall short of IRS estimated tax requirements. The IRS emphasizes that taxes must be paid as income is earned throughout the year, either through withholding or estimated tax payments. If we do not withhold enough from our salary or other sources of income (including taxable IRA distributions), we may be required to make estimated tax payments. Failing to do so could result in a penalty.
Benjamin Franklin famously remarked that "in this world, nothing can be said to be certain except death and taxes." While he may not have originated this phrase, its truth holds strong today.
AMERICA'S PAY-AS-YOU-GO TAX SYSTEM
The U.S. tax system operates on a pay-as-you-go basis. Taxpayers must pay most of their tax obligations during the year rather than waiting until they file a tax return. Generally, at least 90 percent of their taxes must be paid over the course of the year through withholdings, estimated tax payments, or a combination of the two. An estimated tax penalty may apply if not enough is paid this way.
ESTIMATED TAX AFFECTS RETIREMENT DISTRIBUTIONS
According to IRS data, 14 million individuals were penalized for failing to send sufficient quarterly estimated tax payments to the federal government in 2023, an increase of 16 percent over 2022. Much of this increase comes from the growing number of people who perform gig work or who have started their businesses. However, estimated tax payments are not confined to self-employed workers. Those who take distributions from pension plans, IRAs, and other plans can be affected, as well. For example, consider a retiree whose primary income comes from an IRA. If the IRA owner fails to withhold enough when IRA payments are made, estimated tax payments may be required. Or maybe an IRA owner simply takes a large lump sum distribution. If this individual has not withheld enough from the IRA distribution (combined with withholding from other sources, such as income from employment), estimated tax payments may be required. Unfortunately, many taxpayers are taken by surprise by this requirement. In 2023, for instance, the IRS collected $7 billion in penalties from taxpayers who failed to make estimated tax payments. The average penalty was around $500 dollars, but penalties can be avoided easily by following the IRS's published rules.
AVOID PROBLEMS BY WITHHOLDING ENOUGH FROM YOUR IRA DISTRIBUTIONS
Typically, modest IRA distributions do not create an overall withholding shortfall, especially if withholding is not waived altogether. Financial organizations must withhold 10 percent on taxable IRA distributions unless the IRA owner elects a different amount. This election can range from 0 – 100 percent and is valid until the IRA owner revokes or changes it. Keep in mind that the 10 percent default amount may not be sufficient withholding to cover the recipient's tax obligation.
Example: Fritz's federal marginal tax rate is 22% based on his earnings and other income. If he elects only 10% withholding on an IRA distribution, he will have a shortfall unless he "over withholds" from another income source, such as on his income from his employer. If Fritz pays less than required to the IRS during the year through withholding and paying estimated taxes, he may be subject to a penalty based on the shortfall.
Fortunately, if you have failed to pay enough to the IRS this year—either through withholding or through paying estimated taxes—you can remedy this underpayment by increasing your withholding to meet your prepayment obligation by year-end. On one hand, if you miss a required quarterly estimated tax payment, you can still be subject to a penalty even if you increase a future estimated tax payment later in the year. But on the other hand, by withholding an additional amount by year-end, you can address the shortfall while also avoiding an underpayment penalty. For whatever reason, prepaying your tax obligation through withholding confers more benefit than using estimated tax payments. For example, if you missed one or more estimated tax payments for 2024, you could increase your withholding from your weekly paycheck to make up the difference. Alternatively, you could take an IRA distribution and withhold 100 percent of this amount to cover your under-withholding on other income. (If you have the funds to roll over this IRA distribution within 60 days, so much the better.) In either case, if your withheld amount equals the amount that would have been required under your estimated tax payments, no underpayment penalty will apply. When taking a distribution, you may refer to IRS guidelines found within Marginal Rate Tables and State Tax Withholding Information.
WITHHOLDING WRAP-UP
As we approach the end of 2024, you still have time to assess whether you have paid enough to the IRS this year to avoid a penalty for under-withholding. Aside from using the IRA resources linked above, you may also want to consider seeking tax or accounting advice. Although STRATA does not advise IRA owners about whether to take distributions, helping you understand your options is always part of the service that we provide. Contact one of our self-directed IRA experts or review STRATA's IRS Reporting section in our Self-Directed IRA Knowledge Center to learn more about your withholding options.
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