Handling the Tax Bill on a Roth Conversion
You may need to have more withheld from your paycheck or make larger estimated payments.
I converted my 401(k) to a Roth IRA in 2010 and took advantage of the option to split the tax on the conversion between my 2011 and 2012 returns. Do I need to increase my withholding for 2011 or make quarterly estimated tax payments to avoid an underpayment penalty?
You might be okay for 2011, but you’ll probably need to withhold some extra money in 2012.
The amount converted to a Roth IRA is taxed like ordinary income from a job. Normally, you’d get hit with an underpayment penalty on your 2011 return if you failed to pay at least 90% of the tax you owe through withholding and/or estimated taxes. But there’s a safe-harbor rule designed for people like you who experience an unusual bump in income: As long as you pay at least 100% of last year’s tax bill (or 110% if your adjusted gross income is $150,000 or more), you’ll avoid an underpayment penalty. And in any case, the underpayment penalty does not apply if you owe less than $1,000.
But this safe-harbor rule generally helps only with a one-year income blip. If your regular withholding falls short of covering your 2011 tax bill, then you may want to boost your withholding or pay quarterly taxes in 2012 to avoid an underpayment penalty, says Mark Luscombe, principal tax analyst with CCH, a tax information and software company.