For many of us, paying income tax isn't a concern. We work, we earn a salary, an appropriate amount is taken out of our paychecks by our employers, and that's that. We don't think much about it until it's time to file income tax returns every April.

However, if you’re retired and taking distributions from your retirement accounts, you likely have multiple sources of taxable income that aren’t related to employment. The burden of paying taxes falls on you, and when it’s up to you to pay the tax bill, it’s possible you could end up paying too much, too little, or even paying penalty fees.

That’s where financial planning services can help guide your decisions and understand the risk of costly tax missteps. With the support of experienced wealth planners, you can explore smart strategies such as one-time “tax withholding distribution” from a Traditional IRA or other retirement accounts. This one-time payment could, simplify the tax-paying process, and fulfil your tax liability for the whole year.

Fortunately, you can reduce the risk of running into these problems with a one-time “tax withholding distribution” from a Traditional IRA or other retirement accounts. This one-time payment could reduce stress, simplify the tax-paying process, and fulfill your tax liability for the whole year.

Let’s briefly recap your options for paying taxes in retirement.

How to Pay Taxes in Retirement

In most cases, paying income tax on your retirement account distributions works just like paying tax on your salary: The IRS withholds a certain percentage from each distribution based on what your tax liability is assumed to be for the year. Your income from the previous year also helps determine your current year's tax liability. A standard amount may be something like 10%, but this percentage depends on many factors, like the types of accounts you own and how many distributions you take throughout the year.

You can also take another approach: make quarterly estimated tax payments based on how much you expect to pay in taxes. Rather than having a certain amount withheld from your retirement account distributions, you keep 100% of the distribution and then make payments to the IRS throughout the year.

These methods, however, can be complicated. Keeping track of withholdings throughout the year can be challenging, depending on your circumstances. It can also be difficult to remember to make estimated quarterly payments on time, as well as determine what amounts those estimated quarterly payments should be.

Get premier guidance from one of our tax specialists. Book your complimentary strategy consultation now.

One-Time Tax Withholding Distribution

In some situations, it may make sense to skip tax withholding for specific transactions and avoid quarterly estimated tax payments. Instead, another approach is to wait until late in the year to calculate the amount of tax owed more accurately. Then, if done correctly, you can withhold 100% tax from a single late-year distribution to meet the year’s tax obligations.

This strategy simplifies the process by having the funds come from one source yearly instead of having tax withholding come from multiple income sources or making quarterly estimated tax payments. This way, you can use the entire amount of the late-year distribution to pay the probable tax bill.

There are three advantages to this strategy:

1. Simplify the tax-paying process
2. Provide more time to determine the correct amount of tax to be paid
3. Potentially generate earnings on the funds that would have been used to pay taxes during the year

Often, the tax withholding distribution late in the year is immediately followed by an equal payment from the individual's taxable account to the retirement account used to make the distribution, thereby avoiding more tax on the retirement account distribution.

The technique described here provides more time to determine the correct amount of tax, especially for clients with variable income, because the amount of tax due can be calculated towards the end of the year instead of guessing earlier in the year. People generally have a good idea of their tax situation in November or December. By waiting, the funds that would have gone to taxes could stay in a retirement account throughout the year, potentially earning interest they would not have otherwise.

Note that when tax withholding is completed from a retirement account, it is treated as being made pro-ratably throughout the year. From a timing perspective, withholding from a retirement account distribution in January is treated the same as withholding from a distribution in December. Thus, there is no downside to waiting for withholding until late in the year, when you can accurately estimate the amount and earn more interest income.

Savvy Tax Withholding Strategy

To see how such a plan might work, suppose a hypothetical John Smith has not made any estimated tax payments or elected any withholding to cover his tax bill by December 2022. Then, John calculates he will owe $30,000 in tax, so he takes a $30,000 distribution from his IRA and designates $30,000 of tax withholding. The next day, John moves $30,000 from a taxable account to that Traditional IRA, so the $30,000 distribution is considered “rolled over” and not counted as taxable income.

Generally, you have 60 days to roll over the amount of money used for the tax withholding distribution back to the IRA or other retirement account from which the money came to avoid income tax. Individuals can make only one rollover from an IRA to another in any 12-month period under this 60-day allowance. Note that Roth IRA conversions aren't subject to this once-per-12-months rule (more below on how Roth IRAs can fit into this strategy).

Suppose you will perform a rollover or conversion by taking advantage of the 60-day window. In that case, we recommend you complete the rollover within a day or two of the tax withholding distribution. Thus, this strategy only works if you already have the funds and are ready to act accordingly. This strategy shouldn't be treated as a loan to pay your taxes. The 60-day window goes fast, and you don’t want to end up paying taxes on the money you used to pay your taxes!

Looking at a Real-World Example

Keep in mind that these tax withholding distributions can go beyond the tax owed on retirement account distributions. If executed properly, they can cover the tax from all sources of income.

For example, let’s look at a real-life case study for a client we’ll call Ann. Ann owns a successful, independent pet store, and her estimated taxes for one recent year were going to be $200,000 per quarter, based on the prior year. However, a big box retailer moved nearby, causing Ann to fear her business would fall into the red.

Not wanting to commit to that tax obligation, Ann omitted the estimated tax payments. As it turned out, the big box retailer alienated the community, and Ann’s company had its best year ever! We had Ann take $800,000 out of an IRA in December of that year, withholding 100% of that $800,000 to cover federal and state tax.

Ann wrote an $800,000 check back to the IRA on the same day to avoid any tax on the distribution. She was extremely grateful to use several hundred thousand dollars for working capital during the year. On the other hand, if her business had lost, it would not have needed to make such a large December distribution—or could have made no distribution at all, with no tax due.

Creative Roth Conversions

As mentioned, Roth IRA conversions aren't subject to the once-every-12-months rule for 60-day rollovers. Therefore, you may use a different version of a tax withholding distribution for these transactions.

In a Roth IRA conversion scenario, the account owner would have a reasonable amount of tax withheld from the conversion, even if other funds are available. Then, the taxpayer would make up the difference by using additional funds to write a check to the Roth IRA within 60 days to complete the conversion of the entire amount.

For example, on a $50,000 Roth IRA conversion, $15,000 would be withheld to cover the tax, so $35,000 would be converted immediately. Then, $15,000 would be deposited from other funds to complete the $50,000 conversion. This simplifies matters and removes the Roth IRA conversion from other concerns about the tax owed at the end of the year. This prevents the client from making estimated tax payments or using the complicated annualized income method to avoid underpayment penalties.

Are Tax Withholding Distributions Right for Me?

Tax withholding distributions are not for everyone, but they work well for certain people who know what can be done. Take some time to discuss with your financial advisor if tax withholding distributions are right for you.

Additionally, some of these strategies take advantage of the 60-day rollover rules. We don’t advocate using rollovers unless it is necessary. Moreover, the restrictions on IRA rollovers may cause us to use other accounts such as solo 401(k)s for any rollovers, if possible, as solo 401(k)s are not subject to the once-every-12-months rollover rule.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended as a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

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