Estimate Your Tax with Proper Planning

Estimated taxes, something most working Americans don't have to deal with or may not even is aware of, can be a hidden cost when converting traditional IRAs to Roth IRAs. With proper planning, however, this potential trap can be easily avoided.

Estimated taxes are payments we must make four times a year to the Internet Revenue Service if the amount withheld for taxes at work or elsewhere does not meet certain minimums. If we fail to make the required estimated payments due April 15, June 15, Sept. 15 and the following Jan. 15 for each tax year we will owe a penalty for underpayments. The penalty, a variable interest rate set by the IRS, stood at 4 percent for the first quarter of 2010.

This is not a problem for the majority of American workers, who tend to have too much money withheld from their paychecks and get large refunds. But the income from a large Roth IRA conversion is likely to create a tax liability that may trigger the need to increase withholding and/or to pay estimated taxes.

Starting in 2011, income from a conversion must be reported for the year the conversion is made. But for conversions made this year, taxpayers can report either the entire conversion income for 2010, or half of it for 2011 and the other half for 2012. This latter income split is the default option, or what will happen if the taxpayer does not choose otherwise.

The decision of when to report the income is not made until the taxpayer files the 2010 tax return in 2011. Therefore, taxpayers choosing to report the Roth IRA conversion income for 2010 may discover after the fact that they owe a penalty for not having enough withholding and/or not paying enough estimated taxes in 2010.

But a penalty can be avoided by using any of three "safe harbor" methods. The easiest to implement it's foolproof and you don't have to make any estimates is to have your withholding and any estimated tax payments add up to 100 percent of your total tax liability for the previous year, or 110 percent if your adjusted gross income was higher than $150,000 ($75,000 for married taxpayers filing separately).