IRAs Can Be Tapped to Help Pay Taxes
Drastic times sometimes call for drastic measures.
Americans who realize that they’ve substantially underpaid their 2002 income tax -- usually because they had a major life change such as a job loss, marriage or divorce during the year that threw off their tax planning -- may want to do the unthinkable: Tap their individual retirement accounts.
Taking money out of an IRA before retirement usually generates painful state and federal taxes and penalties that can eat up half of the account’s value. But in the right circumstances, an IRA can be used to pay taxes, rather than trigger them.
“This isn’t something that the average person on the street would know about,” said Martin Nissenbaum, tax partner with national accounting firm Ernst & Young in New York.
There are two little-known strategies that use a traditional IRA or a Roth IRA to either reduce a tax bill or pay it with IRA “withholding.”
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IRA Distribution
The first is a timing move that’s aimed at eliminating interest penalties for those who substantially underpay their taxes.
The government requires individuals to pay income taxes throughout the year, either through payroll withholding or quarterly estimated payments. If those payments prove insufficient -- and the taxpayer doesn’t fall under certain “safe harbor” exceptions -- the IRS assesses an interest penalty on the underpaid amount. The current annual interest penalty is 6%.
Because the payments are supposed to be made in installments throughout the year, it’s too late to send the IRS a check to make up the shortfall. However, tax payments that are made through withholding -- as opposed to just sending in a check -- are considered to have been paid evenly throughout the year, even when they’re not, Nissenbaum noted.
To create enough last-minute withholding to cover a big underpayment, a taxpayer can request a distribution from an IRA. Instead of having the check sent to the account holder, Nissenbaum said, the money can be withheld and sent directly to the IRS.
Custodians typically withhold 20% of IRA rollover distributions for tax purposes when the account holder is taking the payment personally. To have more than 20% withheld, all the taxpayer needs to do is ask, Nissenbaum said.
A taxpayer who had underpaid taxes by $10,000 could avoid $375 in underpayment penalties by using this strategy. (Although the interest penalty is 6%, the penalty is levied on just the underpaid amount, which rises to the full $10,000 by the end of the year.)
The catch: The taxpayer must put the exact amount of the distribution back into the same IRA or into another IRA within 60 days to qualify for nontaxable IRA “rollover” treatment. After the 60-day deadline, the $10,000 is considered a taxable distribution, triggering heavy penalties.
For instance, a taxpayer in the 30% federal bracket would pay $4,000 in federal taxes and penalties -- 30% of the amount in tax and 10% in penalties. In California, state taxes and penalties would add more than $1,000 to the bill. All told, this taxpayer would lose half of the IRA’s proceeds to penalties and taxes -- just to save $375 in underpayment penalties.
“If you are going to do this with an IRA, you have to make sure that the custodian understands what you are trying to do and that you get the money back in an IRA within 60 days,” Nissenbaum said. “That is absolutely critical.”
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Taking a Loss
The other strategy for using an IRA to pay taxes requires a Roth with money-losing investments -- not uncommon in today’s market.
Roth IRAs do not offer upfront deductions, but allow tax-free withdrawals at retirement. Taxpayers who meet certain income restrictions can contribute as much as $3,000 annually to the accounts. Like traditional IRAs, investment income earned within these accounts is tax-deferred. And losses suffered within the accounts are not tax deductible.
But if a Roth account is closed -- all of the principal is taken out -- the account holder can write off any lost principal as a miscellaneous itemized deduction, said Ed Slott, a New York tax accountant.
The caveat: Miscellaneous itemized deductions can be used only once they exceed 2% of the taxpayer’s adjusted gross income. In addition, they’re a so-called preference item under the alternative minimum tax system, which means taxpayers should do a careful projection before closing the IRA to make sure they’ll be able to use the deduction, he said.
“In the worst case, you could be out the IRA and unable to use the deduction,” Slott said.
Complete instructions on how to recognize a loss on an IRA investment are included in IRS publication 590, Slott said. The publication can be downloaded from the IRS Web site at www.irs.gov.
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Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes. com. For past Personal Finance columns visit The Times’ Web site at www.latimes.com/perfin.
