Using an IRA Distribution and Withholding to Reduce Estimated Tax Payments

A little-known fact about how withholding works for IRA distributions can work in your favor. While withholding from a paycheck and estimated tax payments are credited as paid during the quarter actually paid, it’s different for withholding from an IRA distribution.

When you have taxes withheld from a distribution from an IRA, no matter when it occurs during the calendar year, it is treated by the IRS as having been withheld evenly throughout the tax year. This means that if you had the bulk of your income in the first quarter of the year, you could take care of the tax burden with a distribution from an IRA and withholding enough tax even in late December of the same year, and there would be no penalty for underwithholding.

So – many folks find themselves in this position, especially in years when income is is not equal in each quarter, or if the tax burden was not known or misunderstood throughout the year.

This method could be used by anyone at any time, as long as you have access to your IRA funds. For example, if you are required to take a distribution, that is, if you’re over age 73 these days or you have an inherited IRA, you could use that distribution to cover your tax burden for the entire year (if it was enough).

Rather than making quarterly estimated tax payments throughout the year, toward the end of the year you could instruct your IRA custodian to distribute enough funds to cover the tax burden for the year (and don’t forget to include the amount of your IRA distribution in your calculation). Then you would also instruct the custodian to withhold the distribution as taxes, using form W-4P.

The one downside to this method is that if the IRA account owner dies before the distribution with withholding for the tax year (and let’s face it, this will probably happen at some point), then the estate will owe penalties for underpayment of estimated tax for that year.