Withholding Taxes from IRA’s and 401k’s
In my role as an advisor and financial educator, I take time to explain financial concepts that people do not often think about or know to think about. While there are some very easily understood concepts out there, sometimes I am reminded that not all topics make sense at first blush.
Taxes on My Taxes!?!
An often confusing aspect of withholding for taxes from an IRA or 401k is that the tax withholding itself is also subject to income taxes. That’s right, if you withhold taxes from your IRA or 401k, the withholding itself will be taxes.
Taxes on a Target Gross Distribution
If you are targeting a 20% tax withholding on a $1,000 distribution, the calculation is simple.
The gross distribution is just $1,000 so your tax withholding will be $200 ($1,000 x 20%) and you will receive $800 ($1,000 – $200).
Taxes on a Target Net Distribution
If you are targeting a specific net of taxes distribution, the math gets a little funny. Let’s say instead you want $1,000 sent to you after 20% taxes.
You may be tempted to take $1,000 x 20% and withhold $200 but that is not the full calculation. The reason is that now you have actually distributed $1,200, not $1,000. If you only withhold $200, your actual withholding would only be 16.67% of the total not 20%.
To calculate the full distribution that would truly give you a 20% withholding, you need to Gross Up the distribution by withholding taxes on the tax withholding itself! So the $200 withholding will have 20% withheld ($40). Then the $40 will have 20% withheld ($8). And so on and so forth. So you get the picture, here is what would happen to $1,000 net of 20% tax withholding:
There is of course a short cut to this amount without having to perform multiple calculations on decreasingly small withholdings.
To calculate the gross distribution needed after a given tax withholding, just divide the net amount by one minus your desired tax withholding:
For example, $1,000 / (100% – 20%) = $1,250. Easy as that.
Pre-59 1/2 Tax Withholding Trap
Now that we’ve learned that tax withholding is subject to taxation, a common trap might occur if you are withholding taxes from an IRA or 401k pre-59 1/2 to cover taxes for say a Roth Conversion.
While the conversion of money itself is not considered a distribution from the account, any tax withholding is and will result in a 10% penalty being assessed on the tax withholding.
For example, if you converted $100,000 and estimated that you would pay 20% taxes. If you didn’t have the cash to pay the extra taxes and withheld 20% from the conversion, here is what the result would be:
Roth IRA would receive $80,000 which would be taxed at your ordinary income tax rates. As the conversion is not a distribution, there is not a penalty.
Taxes Withheld would be $20,000 which would also be taxed at your ordinary income tax rates. However, the $20,000 is a distribution and is also subject to the 10% penalty resulting in an extra $2,000 in tax liability.