Archives for December 2020

A reader writes in, asking:

“I was wondering if you’ve discussed taxes on Roth conversions before. Specifically, I’m really confused on whether or not I would need to make estimated tax payments to the IRS. Does it matter when I do the conversion, January vs. December, for instance? Would I make a single estimated payment, or would I have to make four during the year? I do NOT currently make estimated payments. My wife and I file jointly and have taxes withheld from our paychecks and typically may owe a few grand at most in taxes in April.

Maybe a post about estimated taxes in general would be helpful.”

Yes, a Roth conversion could cause you to need to make estimated tax payments.

There are two ways to avoid penalty for underpayment of estimated taxes.

First, you will not owe any penalty if your total tax for the year, minus your withholding, minus your refundable credits is less than $1,000.

Second, you will not owe any penalty if:

1. Over the course of the year, you paid (via withholding and/or estimated tax payments) at least the smaller of:
   • 90% of your total tax for the year or
   • 100% of your total tax for last year (110% if your adjusted gross income from last year was at least $150,000),
2. And your estimated tax payments were each of the required amount and were each made by the applicable deadline.

Estimated Tax Deadlines

The applicable deadlines are April 15, June 15, September 15, and January 15 of the following year. It’s important to note that this isn’t every three months, despite often being referred to as “quarterly” payments. If you make your first payment on April 15, then make your second payment three months later, that second payment is going to be a month late.

Required Amount per Estimated Tax Payment

The required amount for each estimated tax payment is generally 25% of the required annual payment. In other words, if a) you make the same size payment for each of the four estimated tax due dates, b) you make each payment on time, and c) you meet the percentage requirement described above (i.e., 90%, 100%, or 110%), then you won’t owe any penalty.

However, in cases in which your income is earned unevenly throughout the year, the required amount for a given estimated tax payment may be less than 25% of the annual amount.

As a very simplified example, imagine that you have no taxable income whatsoever for the first 11 months of the year. Then in December you do a very large Roth conversion. In such a case, if you make a sufficiently large estimated tax payment by Jan 15 of the following year, you would owe no penalty, despite not having made any estimated tax payment for any of the first three periods.

Form 2210 and its instructions walk you through the details. (Pay particular note to Schedule AI — the “annualized income installment method” — for situations in which income varies considerably throughout the year. If you’re using tax prep software such as TurboTax or H&R Block, this article from Harry Sit is likely to be helpful.)

A reader writes in, asking:

“I am tentatively starting to think how taxes affect retirement especially for the ACA purposes, in case it somehow survives the latest current court fight. So, which kind of tax should we be concerned about? When I google this, I can find someone saying ‘marginal tax’ whereas somebody else saying ‘effective tax rate’. So, which is it? Could you direct me to some easy to understand tutorial about it? I certainly cannot plan anything (e.g. 401k to an IRA and then Roth IRA conversions) and staying under ‘the cliff’ unless I understand the basics on this subject.”

Broadly speaking:

• Effective tax rate is useful for budgeting;
• Marginal tax rate is useful for tax planning.

For example, if you’re considering taking a new job and you want to know how much actual take-home pay you would have, given a certain level of gross salary, you’d need to know your effective tax rate. (“How much total tax would I be paying on my total income?”)

But for almost every tax planning decision, we want to know marginal tax rate. For instance, if you were considering a Roth conversion, you’d need to know the applicable marginal tax rate. (“How much tax would I pay on this income?”)

With tax planning, we’re generally trying to decide “should I do X or should I do Y?” And we want to know how the tax bill changes as a result of doing X instead of doing Y. That is, we want to know the marginal tax rate.

This is the case whenever we’re trying to determine the value of a potential deduction (e.g., additional deductible charitable contributions). And it’s the case whenever we’re trying to determine the tax-cost of potential additional income (e.g., additional distributions from tax-deferred accounts). It’s also the case when trying to determine when it’s best to recognize a certain piece of income (e.g., doing a Roth conversion this year as opposed to in a later year).

In all of those cases, marginal tax rate is what we want to know.

What’s Your Marginal Tax Rate?

An important point about marginal tax rates is that there’s more to it than just looking at what tax bracket you’re in. Your actual marginal tax rate for a given type of income could be significantly higher or lower than your tax bracket. This is often the case when additional income causes you to lose out on a particular tax break for which you currently qualify (e.g., your income becomes too high to qualify for a given credit, or a greater percentage of your Social Security benefits become taxable). And the opposite can happen with deductions. That is, in some cases a deduction will cause not only the anticipated amount of savings (i.e., the amount of the deduction times your tax bracket) but also additional savings because now your income is low enough to qualify for some other tax break.

In addition, certain types of income (most importantly, qualified dividends and long-term capital gains) are taxed at different tax rates than ordinary income. Also, when doing the eligibility calculation for various tax breaks, some types of income/deductions count, while others do not — and it varies depending on which deduction/credit we’re talking about.

In my opinion, the best tool for people doing their own tax planning is tax preparation software. You can create a hypothetical return, look at the total tax due, then adjust one factor (e.g., “what if I took another $1,000 from my traditional IRA this year?”). When you see how much your total tax would change, you know your actual marginal tax rate for that hypothetical income/deduction.