Avoiding Penalties on End-of-Year Roth Conversions

Comments Off

A Roth IRA conversion near the end of the year can be a great move for your long-term tax strategy — locking in today’s rates and allowing future growth to be completely tax-free. But there’s a catch: conversions that happen late in the year can create a timing mismatch between when the tax is owed and when you actually pay it.

If you don’t plan carefully, the IRS could charge a penalty for underpayment, even if you pay everything when you file your return in April. Here are some practical tips to help you manage the taxes on a late-year Roth conversion the smart way.

Pay as You Go

The US tax system generally operates as a “Pay As You Go” system meaning you are required to pay taxes based on when you receive income. For example, if you earn income in January, you have to pay taxes in that same period.

If you fail to pay as you go, you’ll face an underpayment penalty which is assessed based on the amount of underpayment and an interest rate charge.

There are two ways you can pay these taxes:

1) Withholdings from Wages, IRA’s, Pensions, or Social Security

2) Estimated Tax Payments (Quarterly Payments)

Let’s follow this example. Assume you have a total of $50,000 from social security and pension paid throughout the year. At the end of the year, you decide to convert $100,000 from a Traditional IRA to a Roth IRA.

Normal Income (Social Security and Pension)	$50,000
Roth Conversion	$100,000

Pay Taxes through Withholdings

Withholdings from the Roth IRA conversion itself are one way to avoid a tax penalty. For example, you can withhold $15,000 from the $100,000 converted. $15,000 would go to the IRS and $85,000 would end up in the Roth IRA.

There are three main benefits to this method:

It’s easy.
Withholdings are deemed to be withheld pro-rata throughout the year removing the risk of underpayment penalties.
Taxes are paid from the investments rather than cash flow.

However, the primary disadvantage to this is that it is generally less efficient than paying taxes out of a taxable account.

Pay Taxes through Estimated Payments

Estimated Payments are quarterly additional tax payments made directly to the IRS to cover your estimated tax liability. See How to Pay Estimated Taxes – Gilbert Wealth

The dates of payments are generally:

Q1 – January to March is April 15
Q2 – April to May is June 15
Q3 – June to August is September 15
Q4 – September to December is January 15 of the following year.

By making estimate payments, you can utilize funds outside of the Roth Conversion to pay the taxes. For example, you could pay $15,000 in a quarterly payment to the IRS from a taxable investment account or cash enabling the full $100,000 to be converted into the Roth IRA.

However, one common mistake when using this method is not understanding how the IRS treats income by default. When performing a Roth Conversion late in the year, the IRS is going to assume you received that income evenly throughout the year. Here is how they view your total “income” of $150,000.

	Q1	Q2	Q3	Q4
Default Assumption	$37,500	$37,500	$37,500	$37,500

This results in an underpayment penalty you didn’t pay enough taxes early in the year.

To correct this, the IRS has Form 2210 which contains Schedule AI (nothing to do with Artificial Intelligence). In this form, you can demonstrate when you received this income which recomputes the underpayment penalty; and if done right, can eliminate it. Rather than the above income view, you can demonstrate to the IRS that your income was actually this:

	Q1	Q2	Q3	Q4
Form 2210 Schedule AI	$12,500	$12,500	$12,500	$112,500

If you choose this method and have a Roth Conversion late in the year (October to December), you can make an estimated payment by January 15 of the following year for the additional taxes. Then by filing the Form 2210 with Schedule AI, you can reduce or eliminate the underpayment penalty.

TIP 1: If it’s a possibility to do an end of year conversion, consider slightly boosting your regular withholdings to account for the higher tax brackets on that income.

TIP 2: Don’t forget about state taxes!

Summary

End of Year Roth Conversions can be a great strategy to save on taxes long term but you need to make sure you execute the full strategy well to avoid penalties which reduce the benefits.

Handled correctly, your late-year Roth conversion can stay penalty-free and position you for decades of tax-free growth — exactly as intended.