First some background:
In order to avoid the penalty for underpayment of estimated tax you must have either 90% of your final 2007 tax liability or 100% of your 2006 tax liability (110% if your 2006 AGI was over $150,000) paid in during the year by withholding and/or quarterly estimated tax payments.
The timing of the payment of the tax is important. The penalty is determined based on quarterly payments.
Withholding is assumed to be made evenly throughout the year. Even if you have all your federal income tax withheld in December it is treated as being paid in equally over the 4 quarters for purposes of calculating underpayment of estimated tax. If you had $10,000 withheld in December it is assumed that $2,500 was paid in for each of the 4 quarters.
Estimated taxes are applied in the calculation when actually paid. If you determine that you need to pay $10,000 in estimated tax for the year and you make the payment in December you will still be penalized for underpayment for the first 3 quarters.
There is an exception. If the reason you will owe an additional $10,000 is because, for example, you sold a vacation home in November for a substantial gain you can make the payment as late as January 15th and avoid the penalty by "annualizing" your income on Form 2210.
Now the strategy:
Suppose in the course of preparing your "preliminary" 2007 tax return you discover that you did not have enough federal income tax withheld from your paycheck and you will owe "Sam" at least another $10,000 because of additional taxable income received at various times during the year. Instead of making a 4th quarter estimated tax payment and risk a penalty for underpayment of estimated taxes you can -
(1) take a $10,000 distribution from a traditional or ROTH IRA in December and elect to have 100% of the distribution ($10,000) withheld for federal income taxes, and
(2) within 60 days deposit $10,000 to another IRA, or back into the same IRA (you shouldn't wait the full 60 days – do the rollover ASAP). Make sure that you rollover this $10,000 on time or else you will be hit with additional tax plus another, more expensive, penalty!
Because federal income tax withholding, from whatever source, is assumed to be made evenly throughout the year, regardless of the date of the actual withholding, your $10,000 will be treated as 4 equal quarterly payments of $2,500 and you will avoid the penalty for underpayment of estimated tax.
This strategy may also work for state income tax underwithholding.
As with any other tax strategy you should discuss this with your tax professional before acting.
I think that should finish my year-end tax planning series. I will let you know if I think of anything else.