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Episode #610 - The Difference Between an IRS Late Payment Penalty and Interest

Roger: If 5% appears too small, be thankful I don't take it all, because I'm the tax man.

Welcome to the show dedicated to helping you not just survive retirement, but to have the confidence to lean in and create a great life, because you have clarity on your plan. Your retirement plan of record, it's so critical, something that's clear to you. And in that plan of record, you're going to have to account for taxes that will be due when you have IRA distributions and do Roth conversions, etc. And we're so used to having this on autopilot via tax withholding while we're working that we can have some unexpected surprises when we retire. So today on the show, we're going to have Erin Coe, a team member. She is an enrolled agent, loves the tax code and is just an awesome lady. Talking through penalties and interest during retirement, what those things are, why we need to account for them, and how to avoid some of those unforced errors. So Erin Coe and I are going to have that chat. In addition, we're going to share a rocking retirement in the wild story as well as answer some of your questions. So let's get this party started.

LOTTIE SAYS SHE GOT CAUGHT UP IN IDEAS ABOUT THE PERFECT RETIREMENT AND IT WAS GETTING IN HER WAY.

First, I want to do a rocking retirement in the wild story from Lottie. I love sharing these real world stories of someone like you figuring it out, figuring out how to rock retirement. Lonnie emailed me and she said you absolutely hit the nail on the head. And I actually wrote the words in your email down on an index card and set it on my desk. And what she's referring to is a conversation we had on a show a few weeks ago where she, I'm going to go quote; she, “wrote down the core intent of retirement planning is to create a great life. We must strive for elegant simplicity in our planning so that we can remain focused on the business of living.” That's what she wrote down on her index card. And she goes on to say, I definitely got caught up in the loop of ideas about the perfect time saving amount way to retire. All of that stuff getting in my way. I just retired this past June and find myself frozen in time. Your words reminded me that I need to focus on the next stage of my life. Bravo, Lottie. 100% get busy living. It is very common for all of these things, all the investment strategy, what's going on in the markets and the economy, all of these things just to float around us and get us distracted. Just organize it, take a breath and focus on creating a plan of record and the whole point of the plan of record is it simplifies the battlefield so you can focus on creating a great life. So I'm so glad. And Lottie, just so you know, not just you, but everybody listens, including me. I go through cycles of this over and over. See, these are lessons that we have to continue to relearn. And I have no doubt that you will, because you sound like you're an intentional lady. So keep doing it.

TODAY WE'RE GOING TO TALK ABOUT PENALTIES AND INTEREST WHEN IT COMES TO TAXES

Roger: Now let's focus on the title topic of this episode, which is explaining how penalties work for taxes as well as interest when you realize income, really anytime, but especially in retirement. And, to do that, I'm going to bring out Erin Coe, an EA and member of our Agile team, to talk through how this works. So today we're going to talk about the difference between penalties and interest when it comes to taxes. And this becomes really important, Erin, because people are used to having withholding from paychecks. And when you retire and you take money out of an ira, all that sort of goes away.

Erin: That's right. And it's up to you to remember to either have withholding or send in an estimated tax payment.

Roger: And the goal here, I think, is to avoid unforced errors and to not have surprises.

Erin: Absolutely. Nobody likes surprises at tax time. It's okay to have that $5,000 bill if you know it's coming, but when it hits you in the gut on April 15, that is not a lot of fun.

Roger: It's more annoying than most things as a surprise because, we all sort of feel we pay the government enough money, and then what? They're taking more and you didn't account for. The fact that you're going to have to have the money to pay can be really disconcerting.

ERIN EXPLAINS THE DIFFERENCE BETWEEN A TAX PENALTY AND INTEREST

Well, let's first talk about the difference between what a tax penalty is and then what interest is.

Erin: Okay, so a tax penalty, the most common one is the underpayment penalty. This is where, for whatever reason, you didn't have enough withholding or you didn't send enough in estimated payments throughout the year to meet at least most of your tax liability. And there's a couple different safe harbors you can meet in order to avoid that, or you can just make sure that you pay more than your tax liability for the year.

Roger: So in this case, when you realize income, the IRS wants its money, it's tax money, and it's due essentially on a quarterly basis, right?

Erin: That's right. You get paid. Uncle Sam wants to get paid.

Roger: If you earn money in Q1, they want their money in Q1. Just like if you get a bill and your Internet bill, they want it monthly. And if you don't pay it on time, they're going to charge you a penalty. And so roughly, and this can be somewhat complicated, how is that penalty determined? I mean, how severe is the penalty? And maybe we use a $100,000 example. Would that be better, you think?

Erin: Sure. Okay, so the withholding penalty, not sending enough in or not having enough withheld can result in an underpayment penalty if you don't meet certain safe harbors. So safe harbor could be 90% of this year's liability, or it could be 100% of last year's liability. And that, that can go up to 110 if you're a high income earner.

Roger: So when we say last year's liability, we mean if I paid in federal tax of $40,000 a quarterly liability, if I paid $10,000 a quarter in the subsequent year, absent high earners, then I meet that safe harbor for penalties.

Erin: That's right. And you'll get to avoid that underpayment penalty.

Roger: Okay, and how severe is it? So let's assume I'm retired, I have no other income, and in the first quarter I take $100,000 out of my IRA and I don't withhold any taxes and I don't pay any quarterly payments. How severe would the penalty be?

Erin: So if you get to the end of the year and you haven't paid in what you owe on that, you're going to have the penalty and you're going to have the interest. And the interest is what accrues quarter to quarter. And that is based on whatever the interest rate is that the IRS is charging. And you can look that up online. And I think you said that it's roughly 8% right now.

Roger: Yes. Okay, so you're going to have interest on your penalty and, interest on your taxes due.

Erin: Yes.

Roger: Okay, so if I take the $100,000 out in the first quarter and I don't make my estimated payment, so I got a penalty and I have interest that's accruing. But I remember it's June, I'm going to make my payment in the second quarter, estimated payment, does that alleviate all this?

Erin: That helps a little bit because the accrual of interest happens each quarter. So say you owed $10,000 for quarter one and you forgot to pay it. But then in quarter two you remembered and you paid $20,000. So you got caught up that One that you missed and you paid the current one. Now the only interest you'll be charged is on that $10,000 check just for the one missed quarter.

Roger: Okay. Okay. So it's like you pay your bill, the interest stops.

Erin: Yep. So catching up is better than just ignoring it and waiting till the end of the year.

Roger: And, I'm trying to understand the difference between penalty and interest. So if I meet my safe harbor, but it's not enough to what my actual tax bill is, will I still be charged interest?

Erin: So if you meet your safe harbor, you won't get the underpayment penalty, but you may be charged interest on the timing of those payments? Yes. What you can do if you end up in a situation where you owe more than $1,000, because that's another safe harbor we didn't mention, and you have interest, is you can try to annualize your income. That's something that you do when you file. You use Form 2210. And if you received your income mostly at the end of the year, it may be that your payments weren't actually due, your estimated payments until the following year, January 15th. So that could be one way of avoiding it. Another way of avoiding these interests and penalties can be to just have withholding done, just like when you were working your job and getting paid. It's a lot easier. And it's assumed that those payments are received equally throughout the year.

Roger: And that's what our default is when we set up a client for payments from their ira, whether it's whenever they need it or on a monthly basis as we do a rough calculation of a payment or in tax payment. That happens anytime money is taken out of an ira. And you can do that for the state level as well?

Erin: Absolutely. Yeah. And that's a smart way to do it.

Roger: Yeah, that's a smart way to do it. What happens with Roger if he takes that first quarter, $100,000 in theory, doesn't pay his quarterlies, doesn't remember it in Q2 or, Q3, and then it's November, December, and he's like, holy cow. I'm gonna. I just listened to something, and I'm gonna have interest and penalties on that money I took out in Q1. Do I have any recourse to mitigate that?

Erin: There is hope for you, Roger, in that situation.

Roger: Yay.

Erin: You can do what's called a withholding only withdrawal from your ira, because the irs, any withholding to be paid again equally throughout the year, just make a withdrawal from your IRA that covers the whole tax liability and basically hand it all over to Uncle Sam.

Roger: So even if I did it in the fourth quarter.

Erin: Sure, absolutely.

Roger: Now, there isn't actually a form of a. That of the form you described. It's just really an IRA distribution where you choose 100% of it goes to the IRS. There's not a special form for that other than the normal form you would fill out.

Erin: Correct.

Roger: Okay. And you can do that for the state level as well?

Erin: Yeah, absolutely.

ROGER ASKED ERIN HOW TO CALCULATE AN ESTIMATED QUARTERLY TAX IF NOT DOING SAFE HARBOR?

Roger: Okay. Now let me ask an obvious question: how do I calculate my estimated quarterly tax if I do take out a hundred thousand or I have some kind of income? How do I even know what my quarterly might be if I'm not doing the safe harbor?

Erin: That is a great question. The irs, of course, has a form for that, because they have a form for everything. It's called a 1040es, and it helps you calculate what your estimated tax payment should be. Like all IRS forms, it's a little long, but it has great instructions. And if you just go slowly and fill it out line by line, you'll make sure that you are staying within the IRS's rules for avoiding the. At least the underpayment penalty.

Roger: Okay. I use this form, and I've never gone through the worksheet because it is. I, have my own hack for how I do it because I have to pay quarterly, and it's worked over years, so I'm fine with it. But.

Erin: So tell us your hack.

Roger: Well, because all of my income, I don't get taxed on, I don't have withholding. So I know roughly what tax bracket I'm going to be, and I know what my average tax rate is. So I just withhold that. I just pay. That's easy enough, that amount. So my protocol, because I don't have withholding from any monies, is if I receive a dollar, I move X amount of dollar to my tax reserve account by that percentage, and then every quarter, I just pay that money.

Erin: That's awesome. So you go in and grab miscellaneous things like dividends and interest and stuff like this, or do you just kind of rough swag it with your business income?

Roger: I rough swag it with my business income, which dwarfs all that other stuff.

Erin: Perfect.

Roger: and I've generally. And it's actually worked out really well. I don't know if it's my CPA or me, but I'm generally within 5,000 either direction at the end of every. Now, that wouldn't be how I would recommend that you do it, at least initially. The point of my saying that is, you can get a feel for this, but it is important to go through the form which can give you tired head. It's a lot of little lines that AI or a computer could easily understand because it's so organized, but the majority of them don't likely apply. And that's why it gets tiring, because you got to read each one. And the terms are a little bit unusual to someone that doesn't deal with this stuff every day. Do you have any, because you do tax returns for individuals as a volunteer through aarp, do you have any hacks or recommendations other than go slow?

ERIN SHARES HER TIPS ON TAX RETURNS

Erin: Go slow is the big hack. And if there's something you don't understand, hop on the IRS website and look it up, the 1040 ES. If you scroll down to the individual area and look at what it's looking for there, really what it's trying to determine is what are your sources of income. And then it's going to come up with a rough number for your tax liability and it's basically almost like a mini 1040.

Roger: Okay.

Erin: And then after it comes up with your rough liability number, it's going to check to see which of those safe harbors may apply to you so that you can take that into account as well. So if you break the form down into two little separate sections like that and realize the first part's looking for to determine your tax liability and the second part's looking to determine your safe harbor, that might help a little bit to, better understand it.

Roger: Now we talked about the extreme. Take a large amount of money from an ira. But what happens if I'm retired and I have a lot of after tax investments and maybe I trade stocks a little bit or I realize capital gains, or I get interest and I get dividends, that gets captured in what we're talking about.

Erin: It absolutely does. That little, mini 1040s, it's going to ask about those things.

Roger: So.

Erin: And the best way to fill that out, honestly grab last year's tax return and have that in front of you. Because a lot of the numbers it's asking for on, that 1040. Yes, you can get right off last year's 1040. And if you know your situation hasn't changed that much, just do the same baseline.

Roger: Yeah, just use the safe harbor. These are the kind of unforced errors that we can have occur if we don't think about this, because we've always had taxes taken out via our paycheck, et cetera. And it goes back to that surprise, I think, Erin, that we talked about. Negative surprises at tax time are more annoying than actually owing the money for sure, because we didn't account for it. It's like maybe you didn't have the money available, whereas if you know that it's coming, at least lessens the blow a little bit.

Erin: That's right. Being prepared is always better than being taken by surprise when it comes to owing money to the government.

Roger: With that, let's move on to answering some of your questions.

LISTENER QUESTIONS

Roger: Now it's time to answer your questions. If you have a question for the show, go to askroger.me, and you can type in your question or leave an audio question. So we have a number of questions today. But before I do that, I was reminded today that I have a correction to make that is critical. I was talking with Karen, who I actually know and is a client, and she called me out on something I said on some podcast that I can't remember, related to the fact that I said something to the effect of, no, I don't know anybody that vacations to Kansas. And I wasn't implying anything about Kansas. I just literally didn't think I knew anybody. And she says, well, first off, Kansas is lovely. She tells me, and you do know someone, because me and my husband do that every year and you know that. So I want to issue this official correction for the record that I do know someone that on an annual basis, vacations to Kansas.

JEFF ASKS A QUESTION ABOUT THE PIE-CAKE EXPLAINER VIDEO

Roger: So our first question comes from Jeff, related to the Pie Cake Explainer video that I created a month or so ago. And we will share a link to that video in our Noodle email this Saturday. In case you missed that, if you like the podcast, you're going to love the Noodle, which is our weekly email where we do a summary of the show and share links to helpful hints and in this case, a video on how to assign a purpose to every dollar for retirement.

But Jeff says, hey, I'm a longtime listener. I love the explanation video. I had been listening for a while and thought I understood what you were talking about with the Pie cake, but the video gave me greater clarity in my understanding. But I do have a question about the planner example you walk through. I noticed on the floor funding model, which is tab two, that I went through where you're assigning exactly where you're going to get the money from each individual account to fund year by year, that it doesn't factor in potential gains, but the expenses do appear to factor in inflation. Is this done for a reason? I can imagine that is a layer of conservative planning that adds a buffer into the estimates. I would appreciate a greater explanation on this point.

You're actually very right, Jeff. So we do factor in inflation because that is generally a thing of life year after year. And we're all going to have our own inflation. So even the inflation number that we're using on that five year cash flow estimate isn't going to be accurate because everybody has their own version of inflation. So that is buffer, but we don't. On the second tab where if you have $1 million IRA and we're saying you're going to get this money from that ira, we don't factor in any capital gains or interest or dividends. The reason we don't do that, Jeff, is that none of those are guaranteed. I guess inflation is not guaranteed, but it's more of a normal thing. But potential capital gains aren't guaranteed. And that's more of a worksheet to determine exactly where you're going to fund each year of your retirement in those first five years than it is a forecast in the future. So it's really just a worksheet. Where do I want to pull the money from? And if you need $100,000 say in year two, what account or accounts make the most sense? And we can only work off of what money you have right now to go through that worksheet. Now when you move to the next tab and we're allocating the assets, there will indeed be interest or dividends or potential capital gains. But it does it, it would complicate the exercise or the point of that step to try to forecast because the variance around what they might be is just too big. It just would complicate it. So it's really more of a worksheet to determine where I'm going to get the money than it is trying to forecast the future in that step of the process. So hopefully that helps answer your question.

DAVE ASKS A QUESTION ABOUT HELPING HIS ELDERLY MOTHER WITH HER FINANCES

Roger: All right, our next question comes from Dave related to his mother. I've enjoyed your show for years and always look forward to each week I'm helping my 83 year old mother with her finances. She will be moving into an independent care living situation that will bump her withdrawal rate to around 10%. I'm wondering how to best decide what a safe withdrawal rate would be for her money to last. I know that the 4% guideline rule, but that is for at least 30 years. How do people adjust their withdrawals as they age when the money only needs to be for 10 or 15 years? Thought you might be able to help me think through this decision.

Dave, it's a good question and maybe a first place to start is just really to go to the RMD tables, the required minimum distribution tables, and look at what percentage the withdrawal is for based off of life expectancy. And at age 83, the current percentage is about 5.6%. So M well above the 4% guide, you know, heuristic that you mentioned. But compare that to 10%. Yeah, 10% sounds very steep, but she's going into a continuing care facility of some sort. M so you also need to assess what her specific mortality rate might be based on her health and other factors. Now, we can go down this math rabbit hole to try to figure this out, Dave, but I don't know how helpful it will be because her expenses are going to be her expenses. So what I would suggest that you do is that you look at what income sources she has. Obviously Social Security, well, I'm assuming Social Security, does she have any pensions, etc. And then what is the base amount that she needs to provide for her life? And that could be obviously food and all the normal things. And then the additional cost of this independent care situation. And build this cash flow spreadsheet out using some simple inflation rates. Just use 2 and a half, 3% on the cost of things and you can make your judgment calls there. Build this out for maybe 10 or 15 years. This can be done relatively simply on a spreadsheet that's going to show you year by year what the cost is going to be to fund her independent living, community, whatever expenses you put into that model and how much Social Security with its COLA adjustment is to offset that. And you're going to discover the deficit for each year. And I would do this for at least 10 years. That would get her to 93, which is beyond normal life expectancy. And you can make whatever adjustments you want to make there based off of health. And you're knowing the situation. Take that and then compare it to the actual assets that she has. And I don't know any of the numbers. You didn't share those. And it will either last or it won't. But it would be good to know that.

Now, I do think you're going to want to have security for at least the next five years of what you expect those expenses to be that need to be paid from her assets, meaning building that income floor. Because the most important part of that part of the equation is the return of her money. And then those moneys should be invested in things that you know are liquid and that will mature when you need them that are earning interest, which as of now I know we just had an interest rate decreased the other day in the 3 to 4% range. So it'll earn a little bit of money, at least for the next five years. And we may want to have a higher than normal cushion or emergency fund for unexpected expenses, health expenses, cost of this move, et cetera, because we can have some spikes here. The difficult part of being in the situation is that we don't have much of an opportunity to invest the rest of it, if there's any for growth because we can't really afford or she can't afford to take the risk that she might lose because of bad markets rather than grow. And that would just exacerbate the entire situation. But I like to map it out this way, Dave, rather than thinking about withdrawal rate because it will become abundantly clear whether it will work or not, but also whether it's going to be you or someone else or Medicaid having to step in at some point in the future. So I wouldn't worry as much about the withdrawal ratio because it's just going to be what it's going to be. If 10% is too high, is there really any room to adjust that if she's in this continuing living or is she just literally going to blow through all of her assets? I would approach it in this way, in this structure because it will start to bring to light, wow, we do need to decrease expenses or this isn't viable. So I need to do my own personal planning or have family conversations or we need to start thinking about Medicare planning because she may need to move to a Medicaid facility when she does go through her assets. So that would be how I would approach it. You know, feel free to email me again if you have any questions.

ROBERT ASKS ABOUT GETTING TWO MORTGAGES NEAR RETIREMENT

Roger: All right, our next question comes from Robert related to getting two mortgages near retirement. I'm 58, planning to retire at 60. He says, “My wife is 59, going to retire at age 62. We live in a rental and have a vacation home which is going to be our future summer home.” He says, “On that future summer home we have a $950,000 mortgage valued on a property valued at 2 million 25 million. We have 5 million in almost all pre tax accounts and we make about a half million dollars a year. Thinking about a second mortgage for a winter house in Florida. is it a mistake to get another mortgage for half a million dollars and us putting $100,000 down or should we continue to rent in the winters? Two mortgages worry us in retirement.”

That's a great question, Robert. So how do we get our hands around this to get to a decision we feel comfortable with on, the surface, Robert, given your resources, the equity in the house and the assets, even though they're pre tax, having that much in debt isn't necessarily problematic, but it's getting it out of the ira. Because I'm guessing that if you didn't have it all in pre tax accounts, you might just pay the half a million dollars for the second mortgage. The way that I would approach it, the way I always approach it, is to build out a retirement plan of record without the second mortgage. So that means that you're going to have your base great life, your wants and your wishes. And part of that is going to be the rental that you're paying in Florida when you go down there, and plus your mortgage payment on your current home, et cetera. Make sure when you add the mortgage on your current summer home into your goals that you make sure that number isn't inflating because that principal and interest payment isn't going to inflate, especially if you have a fixed rate. That's a thing that we often miss. So if you're paying say $4,000 a month on that mortgage, make sure that $4,000 a month isn't inflating in your plan of record that you're building. Bill that out and know whether that's feasible. And I'm guessing that you've done that. And that's going to include the money that you're currently renting the house in Florida for and whatever that amount is. Now, if you choose to decide to buy a place in Florida now we can create a what if scenario off of your current plan of record that you already know is feasible. And you can create. You would start off with, well, what if we bought a house in Florida and we put down a half a million dollars which all came out of our Iraq and plus our $100,000 down even with the tax hit, is that still feasible? Create that what if scenario off of your base plan of record. Then you can create another scenario of what if we finance that half million dollars rather than took money from our ira?

The advantages of doing that is now you are going to spread out the IRA withdrawals to cover the mortgage over say, 30 years rather than doing it all in one year. And it's also going to give you the flexibility to maybe quickly pay it off by being opportunistic when you take money from your IRA in the future based on other factors. Once you two are able to retire plus you may be able to accelerate your payments on this Florida house or while you still have that half million dollar income, but that will help frame it for you. Now, should you worry about having two mortgages during this transition? If you build it this way, in following a process, you should start to reveal whether this is getting too far over your skis or whether this is probably totally fine. That is really only knowable within the context of all the other spending that you want to do. But the nice way about doing it this way is when you create that what if scenario, you can run the feasibility test in software and you can make adjustments because you won't have the rental payments for the Florida place if you have your own place.

And similarly, if you do a mortgage now, you can start to explore it. And then when you go to make your plan resilient, you can actually map out to see where I might be able to take more money from my IRA because I'm in a low tax year. This is the way I would walk through it. If your plan is highly feasible or if you're overfunded on this feasibility test, I would use that as to is this risky or not? And the key thing here is what's the worst case that happens? Let's say if you take the second mortgage on this Florida house, and this is something that my coach had to help me when I bought the Colorado house, let's say you buy this Florida house, you get that second mortgage three years down the road, you find yourself in a pickle of whatever sort. You will be able to sell that house. Now, you might not get the amount that you put into it, you may have to sell it at a loss. But this is reversible. And there may be some severity to it, but it is reversible. So that's really what your worst case scenario is, not adding on the second mortgage. And this is that balance between wanting to live great today and feel confident about tomorrow. And it's a tension that never goes away 100%. But if you think through it in a thoughtful way, I think that's a good thing to do now as a prelude to all of that, which maybe I should epilogue, will say now is explore, have some discussions about what is working and what isn't working

Do you really want to own two homes? What is it about what you're currently doing that gives you a lot of optionality that M isn't working? Is it just that desire of wanting to have two of our own places? I get that because I have two places. Or is it actually working? So come to some, have some discussions about that together. And then secondly, if it isn't working, does it have to be now? Or can you be opportunistic market wise or housing wise, etc. Does it ha. Then it can be about timing. Yes, this is a great idea. We like it. But maybe it's not the season of life because we still have two high paying, high stress jobs. So I think that's a great discussion to have. So in two days we have our roundup, which is our annual conference for the Rock Retirement Club in Grapevine, Texas. We have 350 people coming. We're in manic mode. So I'm going to get out of here and we're going to go set a smart sprint. On your marks. Get set. And we're off to set a little baby step we can set in the next or, we can take in the next seven days to not just rock retirement, but rock life.

SMART SPRINT

Roger: All right, in the next seven days, if you are near or in Retirement, download the 1040 EZ form and get an understanding for how to fill that out so you can make sure you don't have unforced errors related to the distributions you make from IRAs or Roth conversions or the taxable income you receive throughout the year. Download that form and then make a decision as to whether you're going to do estimated taxes or whether you're going to set up systems for doing a Safe harbor payment or having money automatically taken out from, say, IRA distribution. Just make sure we don't have unforced errors. That's the key thing.

OUTRO

Roger: So God bless Erin Coe. She was awesome to come on and walk through that and I purposely just wanted to ask questions and be curious about that. She does a great job. She did not know that she was going to have that discussion with you and I on the podcast until we were actually doing it. And she is just a trooper for being thrown in the deep end and swimming and doing it in such a wonderful, graceful way. So thank you so much, Erin. Hope you all have a wonderful day.

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