Two IRS Rules that Could Torpedo Your Tax Planning
By John H. Robinson, Financial Planner (November 2024)
You do not have to search too hard to find advice about Roth Conversions. They have been a hot topic at cocktail parties, in the barbershop, around the water cooler, and everywhere else that free questionable financial advice is dispensed. However, finding sound conversion advice requires a more discerning eye. I touched on this in my September post, “We Fix Bad TikTok Advice.”
That is not to say that Roth Conversions are a bad idea per se, but I do believe they are overhyped. It is important to be aware of both the tax laws involved and the circumstances in which conversions may not be an optimal strategy. This essay highlights two IRS rules that taxpayers should consider carefully before pulling the trigger. While I am not above calling out non-financial planner finfluencers for dispensing naïve advice, I confess that the second rule was brought to my attention by an astute client and was one that I had not previously considered before dispensing conversion advice.
Two Ways to Process Roth Conversions
To lay the foundation for this discussion, there are two ways to convert pre-tax money in an IRA or a qualified plan (401k, 403(b), etc.) into after-tax money in a Roth IRA. The taxpayer can either transfer the entire pre-tax savings amount he/she/they wish to convert into a Roth IRA and pay taxes on the distribution amount from after-tax savings or have tax withheld from the distribution and have the net, after-tax amount goes into the Roth IRA.
The prevailing public perception is that it is always best to pay the tax from savings because it gets more money into the Roth IRA. I agree that there are certain circumstances in which it is almost always a bad idea to have taxes withheld from the gross distribution amount, but I will also present an example where the opposite may be optimal.
Beware the 10% Early Distribution Penalty
While most consumers are aware of the 10% penalty the IRS assesses for distributions taken from IRAs by taxpayers who are under age 59 ½, I suspect that many readers do not know that the 10% penalty applies to conversion scenarios in which the taxpayer elects to withhold tax from the gross amount of the distribution instead of paying from after-tax savings. For example, consider a 45-year-old taxpayer who would like to execute a $50,000 Roth Conversion to fill up his 22% marginal bracket but does not have funds available to pay the tax that may be due. Suppose he decides to withhold 20% for federal income tax with the remaining transferred to his Roth IRA to complete the conversion. In my experience, many consumers are under the impression the 10% penalty would not apply since the taxpayer never took constructive control of the money and the transaction was processed as a direct conversion.
Unfortunately, the IRS sees this transaction differently and deems the $10,000 that was withheld for federal income tax to be an early distribution that is subject to the 10% penalty because this portion of the distribution did not get converted. I agree that this does not seem fair, but fair is not necessarily the IRS’s greatest concern. The government needs the money more than you do. Here is a link to a recent article that supports point:
ROTH IRA CONVERSION CONSIDERATIONS (Ed Slott & Company)
Beware of Penalties for Underpayment Estimated Quarterly Taxes
The fourth quarter of every year sees the most Roth Conversions because that is when taxpayers have the greatest clarity about their taxable income for the year and, thus, the amount they may convert to a Roth IRA without bumping too far into the next marginal tax bracket. As a financial planner, I have those conversations with clients too.
A couple of weeks ago, I met with a client in his mid-60s, who estimated that he could convert around $100,000 while still remaining in the 24% marginal tax bracket. He is over 65 and is aware of the impact of IRMAA on his Medicare premiums. He has also calculated the amount of Net Investment Income Tax he will owe qualifying taxable income over $250,000. He is still working and contributing the maximum annual deferral amount ($30,500) to his employer’s 401(k). He is interested in processing the Roth conversion via an in-service distribution because he has a large, accumulated nest egg in the plan and fears that the plan will be a tax burden when RMD’s begin. He also has ample after-tax savings with which to pay the taxes that will be due on the conversion. I greenlighted his conversion plan.
However, a few days after our meeting, I received an email advising that he is rethinking the conversion strategy because he (and I) had failed to consider the impact of the tax penalty that he may have to pay for underpayment of quarterly income tax and that the penalty was not insignificant. In my reply, I told him that I had never considered that possible consequence before.
I suggested that the fact that he is still working and having tax withheld from his paycheck might make him exempt from the quarterly filing, but it will not. I also suggested just making the tax payment in full before the end of the quarter, but that tack is also flawed because the IRS’ pay-as-you-go system requires the estimated payments to spread the year’s total tax liability roughly evenly throughout the year. Making one big payment late in the year means that the IRS did not have the use of a portion of that overpayment money earlier in the year. The penalty for this underpayment is 8% interest compounded daily!
With that unappetizing information on my plate, my next thought was to nix the conversion idea and just take the $100,000 taxable distribution from his IRA with enough tax withheld to cover the full federal tax liability. This would solve the quarterlies penalty problem. It would also still achieve my client’s primary stated objective of reducing the size of his large pre-tax nest egg by filling up lower tax brackets with taxable distributions.
Then it dawned on me that a better strategy would be to do the Roth conversion, but instead of paying the tax from after-tax savings, which would expose him to an onerous underpayment penalty, he would have the full amount of the distribution’s tax liability withheld from the gross distribution with the net remainder going to his Roth IRA. Ultimately, this strategy still gets the $100,000 distribution out of his 401(k) at a low tax rate and still gets most of it into his Roth IRA. Sure, he gets less into the Roth IRA, but having extra money in after-tax savings isn’t a terrible thing either.
But that is not the end of the story. Because he has after-tax savings available, my client can now contribute the amount of savings equal to the amount of tax withheld on the conversion as a 60-day rollover to his Roth IRA. The 1099-R from the 401(k) plan will now match the 5498 from the Roth IRA custodian. By following this two-step process, the client was able to avoid the underpayment penalty and get 100% of this conversion amount into his Roth IRA. It is a neat trick that saved my client around $1,000 in tax penalties.
This Problem Flies Under the Radar
As you can see, withholding tax from the gross conversion amount seems to be an eminently palatable solution—and one that I almost overlooked because I was preconditioned to think that the tax liability should always be paid from after-tax savings.
The problem of penalties for underpayment of quarterly income tax resulting from year-end Roth conversions only came to my attention because my client is an astute, experienced investor. When he explained the problem to me, my first thought was, how has this issue never shown up on my radar before? I have been in the planning business since long before Roth IRAs were created in 1998 and have digested the many rule changes in the ensuing decades. I believe I am pretty plugged in, but maybe this rule just escaped my attention.
However, when I searched online for supporting literature, I found very little that was directly on point. I guess I can take some solace in knowing that many of my peers have whiffed on this one, too. The following article from Jeff Levine, CPA for Kitces.com, addresses most of the issues but dances around directly recommending withholding from the conversion.
Conclusion – Thoughts on the State of Online Financial Planning Advice
Some readers may be tempted to clap back at me for calling out the laymen finfluencers for giving naïve guidance when this experience exposed me for doing the same.
My pre-emptive response is that this example illustrates why an experienced financial planner will almost always be more knowledgeable than the TikTok and YouTube crowd. My advantage is not necessarily that I am any smarter than the armchair planners, but rather that I have experience with the financial plans of hundreds of clients over my career, while most of them have only their own experience to draw upon. While I do not disagree that all my acquired knowledge is available for free on the Internet, the problem is (1) that influences “don’t know what they don’t know” (i.e., it is difficult to search for a particular rule without being first exposed to the issue that causes the need to know it) and (2) it is difficult to retain information from reading it without applicable context. Nearly all my acquired knowledge comes from tangible experiences just like this one.
Lastly, one of the reasons I am so critical of finfluencers—including those who are professional planners—is that there is just so much flawed advice being given. I have stopped using AI to assist with writing content for my blog because so much of the crowdsourced data surrounding tax and estate planning laws is inaccurate. My advice to everyone is to use high-domain authority sources to verify the advice you are reading/hearing. IRS.gov is a great primary source, though I could not find much that addresses this issue. In this article, I cited Ed Slott and Jeff Levine/Kitces.com as highly regarded domain authorities. [Note: I rank these sources higher than I would articles posted in the mainstream financial news media.]
