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Should You Take an IRA Distribution to Avoid Underpayment Penalties?

In addition to having extra withholding on wages, I plan to use another strategy. I am going to take a distribution from an IRA, and then replace the money within 60 days.

Like many others, I like to pay my taxes as late as possible. I don't even mind paying interest, as I don't find it to be an expensive source of funds. But I do want to stay away from any penalties. I understand the withholding requirements in the Internal Revenue Service chart you provided, but it is not clear to me what penalties (other than interest) are involved. Can you elaborate on that?

-- Pete Mazza

Pete,

Taking a distribution from your IRA is a perfectly reasonable way for some people to avoid getting hit with a big underpayment penalty, which, by the way, is just interest. But be aware that if you don't have extra cash lying around to replace that distribution within 60 days, you could be looking at a huge tax hit.

When you take a distribution from your IRA, you withdraw money from your retirement fund. So if you believe this is the right option for you, call your IRA custodian to request a distribution from your IRA account and have the entire thing withheld for taxes. Since the Internal Revenue Service assumes that those taxes were withheld evenly throughout the year, you won't get penalized for having a lump sum withheld.

Big note: If you're under age 59 1/2 -- the earliest age you can take withdrawals from your IRA tax- and penalty-free -- you'll need to replace that distribution within 60 days to avoid paying both an early withdrawal penalty and ordinary income tax on the amount withdrawn. So you need to have extra cash readily available to benefit from this procedure.

As we discussed in Saturday's Tax Forum , the IRS just assumes your payroll deductions were taken evenly throughout the year, even if they were not. This is not true for estimated tax payments. They must be made in equal installments throughout the year. So if you made a big payment in the third quarter, but didn't pay a thing in the first two, you may owe interest for not paying regularly throughout the year.

Granted, you do have the option to annualize your income, which will show the IRS that your money did not come in equal installments throughout the year. But if your big windfall came in, say, the second quarter, annualizing your income now won't help because you should've paid up back in the second quarter.

So if you woke up in October and realized you should've been making estimated tax payments all along, or your payroll withholding has been too low but still want to avoid underpayment penalties, you might consider tapping into your IRA.

But please, only consider this option if you have the cash around to replace the money. If you don't, then stay clear of your retirement account.

How do you know if you've underwithheld for the year and either should've been making estimates or should beef up your payroll withholding? As a reminder, the rule says that if your 1999 adjusted gross income was less than $150,000, you must pay at least 90% of your 2000 taxes or 100% of the tax you paid in 1999 through withholding, estimated tax payments or credits.

The withholding rate is higher if your 1999 adjusted gross income was more than $150,000. Then you must pay either 108.6% of your 1999 tax or 90% of the current year's tax. Generally, it's safer to use last year's tax bill as your test, because if your estimate for 2000 is off, you'll owe underpayment penalties.

Remember, that's an " or" in there. Many of you wrote in and asked if you have to satisfy both requirements. You don't. "You can owe a boatload of tax this year, but if you covered last year's taxes, you're free and clear," says Bill Fleming, director of personal financial services for PricewaterhouseCoopers in Hartford, Conn.

If you realize you've come up short on the above tests, beefing up your payroll withholding is a good way to go. Just act fast. Many companies do not let you change your withholdings after October.

Or you can try Pete's suggestion and take a "temporary" distribution from your IRA.

Here's how it works.

Typically, there is no withholding on an IRA distribution, says Fleming. "It must be requested."

So regardless of your age, when you take a distribution, request that some or all of it be withheld. Then, assuming you've withheld enough, you've met the above test and you won't owe Uncle Sam any extra penalties.

But if you're under age 59 1/2, you have to put that exact amount of money back into the IRA within 60 days from the day you withdrew it to avoid having the distribution treated as taxable, says Martin Nissenbaum, director of income tax planning at Ernst & Young.

So it's imperative that you have the extra cash around.

Of course, if you're at least age 59 1/2 and you don't need the money from the distribution, you can have the whole thing withheld with no worries.

Note that you can only make a 60-day withdrawal once a year, says Fleming. So if you've already pulled money out of your IRA and replaced it within the 60-day window, this is not an option for you now.

One other warning: Some states may not withhold taxes on your IRA distribution, regardless of your request, says Fleming. In that case, you still may be underwithheld on the state-tax front.

Being underwithheld at the federal or state level will trigger an underpayment penalty, which is an interest charge. The interest is based on what you should've paid at the end of each quarter. So if you should've been making estimated tax payments since April 17, when your first payment was due for 2000, your interest charge will be calculated from that day until you pay.


Send your questions and comments to taxforum@thestreet.com , and please include your full name. Tax Forum appears Tuesdays, Thursdays and Saturdays.
TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.

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