This IRS Penalty Can Cost You Millions! How To Avoid It

Hey everybody, this is Craig Weir. Welcome back to the channel. Hey, did you know that underpaying your taxes when you do Roth conversions can trigger some very costly penalties? Even if you plan to pay by tax time, the IRS does not wait today. What I want to do is just run through real quickly the risks of underpaying taxes on your Roth conversions. We'll talk to you about something called the Safe Harbor Rule and how it applies to all this situation and how you can avoid underpayment penalties and keep more of your money. So at Q3 advisors at our firm, we help a lot of people who have we call IRA millionaires make much smarter tax decisions, especially around Roth conversions and everything else that goes along with it. So let's make sure that you don't lose out on having to pay penalties just because you weren't aware. So I'll offer my normal caveat. We are not CPAs. We just try to give tax planning advice. So double check everything I'm about to tell you with your CPA to make sure that your situation doesn't have something a little bit different or unique about it. Let's start off with just first of all, Roth conversions and what the risk is in underpaying taxes. So the reason that Roth conversions have become so popular is because you can take a big wad of money. And if you're that IRA millionaire, it's seven figures or more, it's going to be taxable to you. As RMDs start coming along, required minimum distributions, that's going to create a tremendous amount of taxable income for you. One of the reasons that Roth people are starting to catch on to doing Roth conversions is because you can choose to pay taxes now at your own time, at your chosen rate. And the money that goes into the Roth for the rest of your life is totally tax free. And there are some benefits. When your heirs get it, it's tax free to them as well. You can withdraw from it, especially if you're already over 59 and a half years old. When you do the conversions, you can immediately withdraw the amount that you converted. You just have to leave the gains there for a five year period of time. That's if you're at least 59 and a half. But they become really popular because all that money is free, tax free. And you kind of insulate yourself from the potential of future tax rate increases that may come down the road. But one of the hidden risk in all this is underpayment penalties because you didn't pay tax as much as you should have, because you had this big IRA conversion that you did. And the IRS expects tax payments throughout the year, not just at filing time. And Roth conversions obviously increase your taxable income, which means that you, you might owe more than you expected. So you want to really make sure you're working with somebody that understands this stuff and that's good with a pencil on putting the numbers to it for you. But failure to pay on time can actually lead to penalties and interest charges. And if you're looking at doing massive conversions like a lot of our clients do, those penalties and interest could be pretty substantial. Let's talk about this thing called the safe harbor rule. It basically is a rule that ensures that you won't owe underpayment penalties if you meet certain conditions. So here's how it works. You're going to avoid penalties if you pay in at least. This is a little confusing, but hang with me. 90% of your current year's tax liability or 100% of your previous year's tax liability. If you're a high earner and you got an adjusted gross income of over 150,000, which you probably will if you're doing conversions, then it's that Safe harbor is 110% of your adjusted gross income. I'm going to give you a very specific example in just a couple of minutes to put some teeth to this for you. But we're just, we'll build the case of what the information is, then I'll make it real life for you. So the reason that this matters so much in Roth conversions is because as you're doing these conversions, it's going to cause large tax spikes for several years where you're, you're choosing on purpose to pay more tax so that you can avoid even a whole lot more tax later on down the road. And if you don't adjust your withholding or get on top of estimated payments, you could owe some penalties. Even if you pay in full by April 15, if you don't pay enough in along the way, you can get hit with penalties. So here's one of those real life scenarios that I told you I was going to offer. How's this really play out? But let's, let's assume your last year's total tax was $40,000. And then you converted $300,000 this year. And that creates an additional tax of. Let's just assume it's another 90,000 of tax that's going to be owed. Here's your solution. There's two different ways of looking at this, number one, you want to make sure to pay in at least 44,000. That's the 40,000 plus the 10% to hit the safe harbor rule. That's going to avoid penalty by prepaying those tax that based on last year's income. So you just want to keep track of how much other tax have I already paid in and just want to make sure that before the end of the year gets here or your last estimated period that you got $44,000 paid in, even though you got more tax owed. As long as you hit that safe harbor, you're going to be okay. And you're not going to have penalties, underpayment penalties, and interest that are due. But what do you do? Let's say you had something really unusual and your last last year's total tax was $200,000. This year it's still $40,000. And you added this conversion of $300,000 on top of it. That created this additional tax of $90,000. You want to make sure to pay in at least 90% of this year's tax, 40,000 plus the $90,000 from the conversion is about $130,000 is what you predict is going to be your, your taxes. Well, there's no reason to go pay 200,000 in, which was last year's tax. So you want to make sure that you pay 90% of this year's tax. So the 40 from all your other income plus the 90 from the conversion is 130,000. 90% of that is $117,000. So instead of having to pay in 130, you need to make sure you get at least 117,000 paid in. Now, truly what a lot of people do is just when they do the conversion, they just get the taxes they withheld or they pay it from another account just to be done with it. But a lot of people fall into a trap of they, I mean, a lot of us don't like to pay tax until we absolutely have to. I just don't want you to wake up on April 15th to realize that you owe several thousand dollars of underpayment penalties because you just didn't understand these two ways of looking at it. Look, if you're, if you're planning on a Roth conversion, don't let underpayment penalties eat into your already existing savings. Know your safe harbor threshold. Adjust your withholding or estimated payments along the year and then plan your tax payments strategically throughout the year so that you make sure that you either hit the 90% or the 110% levels. Right. So look, if you like this kind of stuff and you want to know when more of it's coming down the pike, certainly subscribe that way. When I do something new, which is normally a week, once a week, couple times a week, then you'll be alerted and you'll know kind of how to get that. And if you have some interest in trying to figure out how this really means works for you and you want to personalize Roth conversion tax strategy or you want to talk to us about some financial planning that you maybe need and we can help with those. We don't manage investment assets at our firm and we don't sell any investment products. So we just are really all about just giving you the best fiduciary advice that we possibly can. So I hope you understand this a little bit better. You may have to listen to it two or three times to make it work. But thanks for tuning in. Take care. Have a great day. God bless.