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I recently changed employers, and merged my old retirement account with a Roth account I have with an independent company. A little less than half the contributions were pre-tax, and I understand I have to now pay tax on that amount (nothing was withheld from the balance to avoid the early disbursement penalty), but I am not finding clear instructions on how to do that. I could just pay up at tax time next year, but I'd like to avoid any penalties for not making quarterly payments (I think I'll be above the cutoff for being required to make them with this lump sum). Most of the information on making estimated payments pertains to situations where the employer doesn't withhold for you.

I don't expect this lump sum to change my tax bracket, so can I just make a lump sum of the amount multiplied by my tax bracket to the IRA, and settle up the exact amount next spring? Do I need to fill out an extra form to do this (1040-ES)? Should I expect a W2 from the company that managed the old IRA? Is this lump sum even treated like regular income because it's from selling stocks? I'm not too concerned with overpaying a little, and settling up next spring, but I'd like to avoid any penalties.

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A little less than half the contributions were pre-tax, and I understand I have to now pay tax on that amount ....

When you convert a traditional IRA (or employer plan, see below) to Roth, or when you distribute it, you must pay tax on everything except post-tax/undeducted contributions, in other words on pre-tax contributions and earnings/gains. Depending on how old you are now and at what age you started the account, and thus how long you have had the account, earnings are often the bulk of the balance.

I'd like to avoid any penalties for not making quarterly payments ....

The general rule is that you must pay during the year within 10% of your net tax by withholding plus estimated payments together, or within $1000 by withholding alone. But there is a safe harbor that frequently helps with single-year variations: if you pay 100% of the prior year tax (110% if your prior year AGI was over $150k) you are exempt from the penalty -- and as a limiting case if you owed no tax for the prior year you never have to make estimated payments. Usually for people whose wages stay the same or gradually increase from year to year and have no or little other taxable income, so that wage withholding is accurate, and don't have status changes such as marriage or childbirth, withholding this year will automatically be 100% or a little more of last year's tax. But this year with COVID, and with a change of job, that might not be the case -- look at your actual numbers to check. Also this may not work for people whose pay is mostly bonus based on business performance and thus varies a lot, like some salesmen and investment managers. (Also relevant here: if your yearly combined wages from multiple employers exceeds the Social Security 'base', currently about $138k, they will collectively withhold too much Social Security tax, and the excess is counted as a (refundable) payment on your income tax when you file, see schedule 3 line 11.)

If you need to pre-pay and you have a job, you can either make the estimated payments directly or you can request on W-4 your (new) employer do 'extra' withholding, or any combination that adds up to the required amount. See https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes (which covers all types of non-wage income even though it is navigated under 'self-employed'). Withholding is the easiest, because it is treated as if paid evenly through the year, and thus always timely, even if it wasn't really.

If you choose to use estimated payments:

  1. yes, you use 1040-ES if paying by check, or by cash in-person (not recommended, especially now). But it's very easy to fill out: it contains only your name, SSN, and address, and the amount. You don't need to show your details and calculations at the time you pay, only at year-end on your return. If you pay electronically you only enter your name and SSN and select that it is a 1040-ES payment; the amount is captured automatically.

  2. since you are starting mid-year, on your return you will need to use the 'annualized' method on form 2210 schedule AI to show that not only was your total payment enough, but it is okay that it wasn't until the third 'quarter' because your income varied then. This is a lot of extra work, and requires you to keep more extensive records of everything, which is why extra withholding as above is easier.

Should I expect a W2 from the company that managed the old IRA?

No, you should expect a 1099-R. W-2 is used to report wages, and sickpay that replaces wages, and (oddly) gambling winnings. Various 1099-series forms are used for other reportable income including interest, dividends, (taxable) stock sales, credit card or network payments, contract or other non-employee work, unemployment and state/local tax refunds, and as here retirement payments (including pension and Social Security). You should also get a 5498 from the custodian of the target IRA showing the rollover coming in.

Was the old plan really an IRA? Some employer plans are, like SEP and SIMPLE, but most employer plans are not IRAs. Both employer plans and IRAs get almost all the same tax treatment, especially of conversions and distributions, and including as relevant here 1099-R reporting, but that does not make them the same thing.

Is this lump sum even treated like regular income because it's from selling stocks?

Yes. For investments you hold directly, capital gains from stock held more than a year, and 'qualified' dividends, are treated specially and taxed at lower rates. And they are taxed in they year they occur. For tax-deferred accounts like an IRA or an employer DC (defined contribution) plan, transactions you do in the account are not taxed at all -- you can sell one stock for another, or switch between stocks and bonds and 'cash', as much as you like with no tax, even though these would be taxed if held directly.* But all distributions, and conversions, from a traditional/non-Roth deferred account are taxed at ordinary rates. Plus a separate 10% for early distributions (but not conversions) unless certain exceptions apply.

*: whether you should actively trade in your retirement account(s), and try to time the market etc, is a different Q I don't address. But you can do so without tax.

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    The only thing I would add to this answer, was that any company match is also pre-tax, So in many cases all of the value of the account is going to be taxed on distribution unless the employee made post-tax or Roth contributions. Aug 23 '20 at 11:53
  • I’d add that the irs web site has a nice link to send money online, no form, no check. Basically “my SS# is xxxxx and my checking acct is xxxxxxx..” And, since tax software is usually out by Black Friday (the day after US thanksgiving holiday in November) it’s not tough to start the return that weekend. You’d have a close estimate of the actual tax due by then. Aug 23 '20 at 12:29
  • Great answer, Thanks! It sounds like calling up HR, and asking them to withhold extra will be the easiest for me. To clear up some things I didn't understand 100% initially: I suppose it wasn't really an IRA, rather a 401(k), where I made all my contributions after tax, and the employer match was pre-tax. The account I'm rolling that money into is a Roth held with a private brokerage firm.
    – Aaron
    Aug 23 '20 at 15:28
  • @JTP: that's at my 'pay electronically' link. (They actually take ACH and credit/debit cards, but the latter via private contractors who add a fee. Plus using a credit card unless you repay within the grace period means high interest.) If you do need to make in-year payments, an estimate done at end of Nov is not much help; any estimated payment covering Aug is due Sep 15, and requesting increased withholding often takes a few weeks so there might be only one paycheck left in the year, or none. Aug 24 '20 at 11:09
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Let's say the taxable part of the conversion (i.e. the part of the conversion that is attributed to pre-tax funds) is $X. When you do your tax return, the effect of this conversion is that your taxable income is increased by $X, just like if you suddenly got an additional work bonus (or any other taxable income) of $X. So your tax would be calculated on this new amount (which is (original amount) + $X). This basically means that your tax increases from what it would otherwise be by $X * (your marginal tax rate) (though it's possible the increase goes through into another bracket, in which case, you can think of part of $X being taxed at one rate and part of $X being taxed at a different rate). Let's call the additional tax $Y.

If the withholding from your paycheck normally matches your tax liability about right (not much refund or tax owed), then you would have underpaid tax by $Y this year. One way to handle this, as you have mentioned, is to pay quarterly estimated taxes to cover the difference. Another, possibly better, way is to just increase your withholding from your work paycheck for the remainder of this year to cover the difference.

If, by the end of the year, the amount withheld from your paycheck exceeds either 1) 90% of your tax liability for this year, or 2) 100% (110% for high earners) of your tax liability for last year, you do not need to have paid estimated taxes, and you do not have a penalty. There is no "cutoff for being required to make [estimated tax payments]". You can always cover extra taxes by increasing your withholding from work (if you have a W-2 job) instead of paying estimated taxes, as long as you manage to reach the 90%/100% level by the end of the year, and there is plenty of time left in this year so it should be easily doable, if the conversion is not too large.

If the withholdings from your paycheck do not meet the required 90%/100% level by the end of the year, then you need to have paid sufficient estimated taxes in every quarter to avoid an underpayment penalty. If you paid an insufficient amount in a previous quarter, you will have a penalty even if you paid more in subsequent quarters so you have paid enough total. By default, the required amount of estimated taxes in divided evenly into the 4 quarters, i.e. the required payment every quarter is the difference (between the withholdings and the required 90%/100% level) divided by 4. Since you didn't pay estimated taxes in earlier quarters and this extra income only came in the middle of the year, you can use the Annualized Income method on Form 2210 to calculate the required estimated tax payment for every quarter depending on the tax on the actual income up to that quarter, but that's a lot of hassle. It's easier to just increase withholding so that it adds up to enough by the end of the year.

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