RTS #026 Tax planning doesn’t happen in a silo
It’s important to understand the details of a tax planning strategy on it’s own…but the great news is we aren’t limited to only pursuing one strategy at a time! There are countless examples of strategies that can be combined or leveraged together to increase the value of tax planning in a given year, but with 30 days until the end of 2023, there are two in particular that is top of mind for us:
- Using retirement account distributions to pay taxes through withholdings AND
- The 60-day rollover
We talk all the time about the preferential treatment that withholdings get compared to estimated payments, but that can feel like unhelpful information this close to the end of the year. For working-aged clients, it might not be impactful to know that for 2023, but now is the time to get things on track for 2024 so they don’t end up in the same situation 12 months from now. W-2 wages, however, are not the only way to have tax withheld. Which is where the two strategies above come into play.
Depending on the custodian, it is possible to withhold 99 or even 100% of a distribution for tax payments (federal and state). Which means that a client could have skipped paying taxes all year long, which normally could result in huge underpayment penalties, and then take a distribution from an IRA in December for the taxes due, and the IRS will treat them as if they had been paid evenly throughout the year (which is the superpower of withholdings over estimated payments).
While this addresses the taxes due, you would rightfully question the wisdom of drawing down a tax-advantaged retirement account just to pay taxes. Which is why we included the second piece, taking advantage of the IRS’s 60-day rollover rule. This rule allows an account holder to put the full amount of a distribution back into the retirement account within 60 days of the distribution, and the IRS essentially treats it as if the funds had never left. This, of course, means the client needs to have the funds available somewhere else to put back in the account because the actual funds that left the account were sent to the IRS.
This strategy is ideal for clients expecting a large balance due who have the funds to pay the taxes but are looking for a way to avoid underpayment penalties. The timing is very important; you’ll want the distribution to be made before 12/31 so the tax withholdings apply to the right year. You will also want to make sure you don’t flirt with the timing on the 60 days. The IRS is not particularly forgiving; make sure you have a cushion. Also, on the topic of timing, the IRS does not want this rule to be abused, so it is restricted to being able to be done once every 12 months…so a married couple could alternate which spouse does it and could theoretically take this approach every single year.
What can you do about it?
To help with something like this, you have to be involved in your client’s tax life. Getting tax returns every year so you know how they typically wind up at tax timing (payment due vs. refund) and then staying on top of life changes to make sure you know when a tax year might look a little different, and this strategy might come into play for just the one year (i.e., a large capital gain or severance).
Keep in mind that proactive systems are the best way to ensure success. This isn’t something to test out for the first time on December 24th. If you have clients for 2023, you know will have a big tax bill; this is a strategy worth considering for this year and something to have on your radar moving into 2024.
If you are an RTS Member, you can watch the most recent webinar recording where Michael Henley and Alison Brooks joined the session to share several tax strategies they use with their clients, including this one.
Happy Tax Planning!