Simplify Paying Taxes Using Your RMD
When you are still working, the withholding on your paycheck should ensure that you have enough money being sent into the IRS to satisfy their pay-as-you-go demands. The rules state that you must pay 90% of your current tax year's liability or 100% of what you owed the previous tax year to skip the underpayment penalty. (110% of your prior year if your AGI was over $150,000)
When you reach retirement and no longer have that W2, things can get a bit more complicated - especially when you income includes decent amounts of interest and/or dividends. And unlike withholding from paychecks, withholding from retirement accounts and social security is almost always voluntary.
One way to handle this to go through the process of having taxes withheld from each of your individual retirement accounts. For instance, if you want federal taxes withheld from your Social Security benefits, you must file Form W-4V with the Social Security Administration. You can choose to have 7%, 10%, 12% or 22% of each monthly benefit withheld. If you are receiving pensions or annuities, you can file Form W-4P with the payor to have money withheld for federal taxes.
If you have traditional IRA distributions, the law requires that 10% be withheld for the IRS unless you tell the custodian otherwise. You can choose to have nothing withheld or ask as much as 100% be withheld.
If you have multiple retirement accounts, this can get complicated trying to match the withholding to your actually tax due. It gets even more complicated when your income is also from interest, dividends or stock sales, etc. which commonly do not have any withholding mechanism to use. Then it is your responsibility to make quarterly estimated taxes and send in the money to the IRS.
The payment deadlines for estimated tax payments are April 15th, June 15th, September 15th and January 15th of the following year. It becomes your responsibility to estimate how much tax you'll owe for each tax period and send it to the IRS. Many taxpayers simple divide the previous year's tax liability by four and send 25% on each payment date to use the "100% of last year's tax bill" exception to the penalty. If they have a good investment year, then they just pay the extra when they submit their tax return.
If you have income in retirement that varies greatly from year-to-year and are taking an RMD (Required Minimum Distribution) from a traditional IRA, there may be a simpler way to handle withholding on multiple accounts and filing estimated taxes.
Starting at age 70 1/2, retirees must take RMDs from their traditional IRAs, based on the balance in the accounts on the previous December 31 divided by a factor determined by the IRS.
If you don't need the money to live on, wait until December to take out your RMD and make it large enough to cover your taxes on the IRA and all of your other taxable income for the year. By then, you will know how much money your investments made and how much will be needed to cover your taxes. (A good tax professional can help you estimate this.)
The IRS want you to make estimated taxes throughout the year and if you wait until the fourth quarter to make the entire payment, you can still be sacked with an underpayment penalty. The reason the RDM withdrawal works is because IRA distributions are considered paid evenly throughout the year, even if made in a lump sum payment at year-end.
So if your RMD is big enough to cover your whole tax bill, you can keep your IRA earning money the entire year, avoid withholding on all your other sources of retirement income, skip filing quarterly estimated payments - and still avoid the underpayment penalty.
(Note: This method may not work with all state estimated taxes because some IRA sponsors won't withhold state income taxes.)