In order to determine whether or not you will be assessed underpayment penalties we need to review your specific situation and compare the IRS requirements. First, penalties are charged when your total withholding and estimated tax payments do not equal the smaller of: 90% of your estimated tax for the current year OR 100% of your previous year’s tax (110% of your previous year tax if AGI is greater than $150,000).
The simplest of the two methods is to check and see whether or not taxes withheld this year are equal to or greater than 100% (110% if you AGI was greater than $150,000 in the previous year) of your previous year’s taxes. If they are, you will not be charged a penalty for underpaying estimated taxes even though your tax bill will higher this year as compared to last year.
The other method to calculate your current year taxes to avoid underpayment penalties is to pay 90% of this year’s taxes. This method requires some calculation on your part. Seeking advice from a CPA or tax professional may be warranted in this instance. There is also tax software available that can assist you with this estimation. Make sure to include all sources of income and make sure to estimate the information for the full year.
If your taxes withheld in the current year are less than 90% of your current year tax liability and you have not met the 100% or 110% requirement for the previous year, then you will be charged penalties for underpayment if the underpayment is greater than $1,000. Penalties are assessed separately for each quarter based on when the attributing income is incurred. Therefore you may owe a penalty even if you made up in the underpayment in following quarters by submitting estimated tax payments.
Given the complexities of the tax code, my colleagues and I advise clients to check with their CPA or tax professional in order to verify that transactions, such as a Roth Conversions, are handled properly from a tax perspective.
** The information provided should not be interpreted as a recommendation, no aspects of your individual financial situation were considered. Always consult a financial professional before implementing any strategies derived from the information above.
If there is an underpayment penalty evident when you prepare your return, you can always recharacterize the Roth conversion to "undo" the activity and remove both the tax and penalty. This is just another way to avoid the penalty in the long run.
You can avoid penalties if you make an estimated tax payment by January 17th, or file your return by the 31st. If you made the conversion in the 4th quarter you may have additional leeway. You should consult your tax professional as soon as possible.