How IRAs Can Help Retirees Reduce Or Avoid Estimated Tax Penalties

Estimated tax requirements are a frequent problem for retirees, with many incurring penalties for underpaying their estimated taxes.

Fortunately, there’s a little-known strategy that can help avoid penalties when a retiree realizes late in the year that estimated tax payments have been too low.

Income taxes have to be prepaid during the year. If they aren’t withheld from income, a taxpayer must make estimated tax payments four times during the year.

The estimated tax payments are supposed to be made as income is earned. You can’t avoid the penalty by making a lump sum estimated tax payment by the January 15, 2025, deadline for the final payment for 2024.

A few years back Congress tightened the requirements for estimated taxes, and the IRS put more resources into identifying and penalizing taxpayers who didn’t meet the requirements.

The result, according to annual data released by the IRS, is that estimated tax penalties increased 42% from 2012 through 2017 and increased another 24% from 2017 through 2022.

Retirees are among those likely to be hit with estimated tax penalties. Most retirees were used to having income taxes withheld from their paychecks during the working years and take a while to adapt to making estimated tax payments. Also, calculating the correct payment amount can be difficult when income fluctuates during the year and from year to year.

Higher interest rates are another reason estimated tax penalties have become more likely. People became used to earning very low interest rates on cash balances. The surge in interest rates beginning in 2022 boosted the interest income of many retirees, increasing their required estimated tax payments.

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When estimated tax payments aren’t made by the deadlines or the payments aren’t at least the minimum required, a penalty is imposed. The penalty is interest compounded daily for the period the government didn’t have the money when it should have.

The interest rate is reset quarterly based on treasury debt rates. Any penalty is charged from the day the payment was due until the earlier of the date the tax return for the year was due and the date the payment actually was made.

But there’s an option that can be used late in the year if you forgot to make estimated tax payments earlier in the year or the payments turned out to be too low.

When taxes are withheld from income, the IRS considers the withholding payments to be made evenly during the year, even if there’s a large withholding amount near the end of the year.

That’s where a traditional IRA comes in.

You can ask for a distribution from the IRA late in the year and request a portion be withheld for federal income taxes. Request enough withholding to avoid incurring estimated tax penalties for the year. (Keep in mind that the distribution itself is likely to be taxable, increasing your estimated tax liability for the year.)

But first check with your IRA custodian.

Some custodians limit the dollar amount or percentage of a distribution that can be withheld for taxes. Or they might require that the distribution and withholding be requested by a certain date in order to be processed by the end of the year.

For many retirees, though, the IRA withholding strategy is a good way to avoid the penalty for underpaying estimated taxes.