Planning

Pay Quarterly Tax Estimates in One Fell Swoop

If you’re one of the millions of Americans who are required to make quarterly estimated tax payments to the IRS, you know the process can be a hassle.

First you must calculate what you owe or pay someone to do it.  Then you have to write a check or make an electronic transfer.  If you miss a quarterly deadline or cannot pay the full amount right away, you could face steep penalties and interest.  Moreover, by essentially prepaying most of the tax you will owe on your year-end earnings total, you could be missing an opportunity to maximize the value of your money.

However, if you have an Individual Retirement Account (IRA), you may not have to bother with quarterly estimated taxes at all.  By “borrowing” from your IRA to make a single payment at the end of the year, you can pay Uncle Sam just once—and keep your money invested and hopefully growing for the majority of the year.

Here’s how it works:

If you have income sources that require you to pay estimated federal tax, you can “borrow” from your IRA at the end of the year and direct those funds to the IRS.  Under current tax law, the IRS will treat the payment as satisfying the requirement for quarterly estimated payments throughout the year.  You can then use cash you have set aside in a savings account to replenish the IRA within 60 days.

Technically, you are not borrowing from your IRA.  Rather, you request a distribution from the account that is equal to your estimated tax liability and direct the account custodian to withhold 100% of the distribution for federal income taxes.  If you withhold $50,000, for instance, the IRS will deem it to be the equivalent of four quarterly payments of $12,500 each.  As long as equivalent funds are redeposited into the account, or a different IRA, within 60 days, the transactions qualify as a tax-free rollover transaction.

Taxpayers 72 and older are required to take minimum distributions (RMDs) from their IRAs on an annual basis.  RMDs can be used to satisfy quarterly estimated tax requirements using the same withholding process and, in such cases, funds do not need to be redeposited.

There are many favorable reasons to use IRA funds to pay federal taxes.  To start, you pay once instead of on four occasions, which adds time back to your life.  If you have forgotten or have failed to make full quarterly payments, “borrowing” from your IRA at the end of the year allows you to avoid interest and penalties which would otherwise apply.  Last but not least, this strategy enables you to keep your savings in an interest-bearing account throughout the course of the year as opposed to making 4 interest-free loans to the government.

However, the devil is in the details, and you should be mindful of potential pitfalls to this technique.  If you fail to replenish your IRA commensurately within 60 days after disbursement, you could face substantial IRS penalties and interest.  This is a particular hazard for high earners whose taxable income has risen sharply from the previous year since the IRS requires estimated taxes to equal 110% of last year’s taxes or be subject to underpayment.  And of course, interest and penalties would ensue if you do not have sufficient funds in IRAs to cover your total tax liability assuming you skipped quarterly payments along the way.

With the end of the year approaching, it may make sense to look further into using IRA funds for estimated tax purposes.  Bear in mind that each taxpayer’s situation is unique, and I encourage you to consult with your tax professional before taking action.  If this strategy is of interest or if you have any questions, please feel free to reach out to your team at Balentine.

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