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Navigating the 3 estimated tax penalty safe harbors

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Each year, the Internal Revenue Service assesses estimated tax penalties against millions of taxpayers. This added money typically is due the IRS when a taxpayer pays too little total tax during the year.

The last time the IRS released complete estimated tax penalty data was three years ago. The federal tax agency said back then that the average estimated tax penalty, which is based on the interest rate charged by the IRS on unpaid tax, was about $130.

Back in September 2015, the IRS said it was seeing more taxpayers run into the estimated tax penalty. The number jumped about 40 percent from 7.2 million in 2010 to 10 million in 2015.

Both the amount of the average estimated tax penalty and the number of folks who have to pay it could be even bigger now, thanks in part to the Tax Cuts and Jobs Act (TCJA) changes to the tax code.

What's subject to estimated tax: The IRS has been encouraging all taxpayers who have income that isn't subject to withholding — that includes investors, folks with sharing economy side jobs, full-time self-employed individuals and retirees living off pensions — to do a paycheck check-up using the tax agency's TCJA-updated online withholding calculator.

When you're entering earning into the online calculator, don't forget about that couple of hundred from a state lottery scratch off, those sports that paid off or the nice chunk of change you got from renting out your lake house over the summer. Those are taxable, too.

In these earnings cases, instead of telling an employer to change a workplace withholding amount, you need to account for the calculator's suggested adjustments via estimated tax payments.

Four equal payments expected: As the table below shows, the IRS expects you to take out the amount he should get and send it to him in equal installments four times a year. The estimated tax periods are:

Payment #

Due Date

For income received in

 1

April 15

Jan. 1 through March 31

 2

June 15

April 1 through May 31

 3

Sept. 15

June 1 through Aug. 31

 4

Jan. 15 of the next year

Sept. 1 through Dec. 31

The estimated deadlines follow the same IRS rules as annual filings.

That means if you snail mail in a payment with the IRS Form 1040-ES, a postmark of the due date qualifies the payment as being timely filed. You also have all day on the due date to electronically pay your estimated tax bill.

And when the estimated deadline falls on a Saturday, Sunday or legal holiday, you have until the next business day to make the payment.

My earlier post has the scoop on paying estimated taxes.

But since we're talking tax penalties today, below is a look at the three estimated tax safe harbors that can protect those of us trying to navigate treacherous tax waters of these additional payments.

1. Increase workplace withholding: If you have a salaried job in addition to your income that's subject to estimated tax payments, you can reduce or, in some cases, eliminate the penalty by increasing withholding from your 9-to-5 paychecks for the rest of the year.

This also works if you're married and file a joint return.

In cases where one spouse has a job with withholding and the other's earnings are from self-employment income, since all that money goes on one Form 1040 you can use a husband's or wife's withholding to make up the other spouse's estimated payment difference.

2. Use this or last year's tax liability: The IRS says you won't owe any underpayment penalty if the total of estimated taxes that you pay through the year plus any withholding amounts you (or your spouse if filing jointly) paid were at least:

  • 90 percent of your current year's eventual tax bill or
  • 100 percent of your prior tax year's tax liability.

A lot of folks go with the 90 percent option, not wanting to over pay Uncle Sam. But this takes a pretty accurate guesstimate of your current year's earnings.

If you're a freelancer, accurately estimating your income and associated taxes can be difficult. You're not sure when you'll get your next job. Worse, you're not sure when you'll get paid for that job.

Things also are complicated when you have investments. The hubby and I have some holdings that make payouts each December. Some years that's a nice chunk of taxable change; others, not so much.

Given those variables, I opt for the 100 percent safe harbor because it's easier. I can always pull out last year's Form 1040 and see what that tax liability was. Then I just divide it by four and send in the payments each April, June, September and January.

Some years, I end up over paying estimated taxes because I didn't make as much as the previous year, and therefore owed less tax. Other years, I end up having to pay more when I file my annual 1040.

But in either instance, I'm not penalized because I met the 100 percent payment of the previous year's tax due.

EXTRA 1040-ES TAX TIP 1: Get the threshold right. One quick note if you use the 100 percent of last year's taxes threshold. This is your tax liability, not the amount of a check you might have written when you sent in your return.

Say your tax bill last year was $10,000. You had $7,000 withheld from your paychecks. You also paid $2,500 in estimated taxes. That meant when you filed your 1040, you wrote the U.S. Treasury a check for $500.

Don't be misled by what you owed at tax filing time. The estimated tax threshold is 100 percent of your overall tax liability. In this example, that's the $10,000, not the $500.

Also, this particular safe harbor threshold waters are little choppier if you make a lot of money.

The threshold as it relates to last year's taxes is 110 percent when your adjusted gross income is $150,000 or more. That amount applies to both single taxpayers and married couples filing jointly; it's $75,000 or more for married taxpayers filing separately.

In these cases, if your prior year's tax liability was $20,000 (a higher example amount here since you're making the big bucks!), then you must make current tax year 1040-ES payments of $22,000. That's your last year's liability of $20,000 plus 10 percent, or $2,000, more.

3. Make annualized estimated payments: There's also a third way to pay your estimated taxes, the annualized income payment method. 

Rather than paying your full estimated tax amount in equal installments for the full tax year, the annualized income installment method lets you pay estimated tax for each period based on an estimate of income and deductions for that time frame, 

You still need to pay tax on at least 90 percent of your current year's annualized income. However, you may be able to skip one or more of the four estimated payment deadlines if you made no money during the tax quarter.

Say, for example, that you owed $15,000 in taxes for the year, but $10,000 of it was from earnings in the second quarter of the tax year. Rather than divide the $15,000 by four and pay it in equal installments for each payment period, you can remit the tax due on the $15,000 in the appropriate quarters in which you receive it. 

In this case, the taxpayer made $2,000 in the first quarter; 10 grand between April 1 and May 31; $2,000 in the third quarter; and finished up the year with $1,000 in earnings. She paid taxes on those amounts in each quarter. The annualizing option meant she didn't have to come up with big tax payments on income she didn't make for most of the year's months.

The annualized estimated tax payment system works well for individuals whose income fluctuates dramatically, such as landscapers who are flush with clients in the spring and summer, but have very few or none in fall and winter. 

EXTRA 1040-ES TAX TIP 2: The annualized method is harder. Of course, there's a price for precision. The annualized estimated tax payment requires more work and record keeping.

You have to file Form 2210Underpayment of Estimated Tax by Individuals, Estates, and Trusts, with your federal income tax return.

Plus, the annualized method relies more stringently on the U.S. tax concept of pay as you earn, which wage earners experience with income tax withholding coming out of every paycheck. Under this assumption as it relates to estimated taxes, if you miscalculate a quarter's estimate payment using the annualized method, you could be hit with a late-payment penalty for not paying enough in the correct quarter.

Penalties per pay period: While making late-year W-4 adjustments to increase your (or your spouse's) withholding is OK to meet your eventual tax liability, the same tweaking isn't true with estimated tax amounts.

If you think the IRS will let you slide by if you miss one 1040-ES payment and simply add that amount to the next payment or you pay all you owe in one estimated tax payment (typically the fourth one) or you make three small estimated payments and one dramatically larger one (again, typically the fourth one), think again.

Sure, Uncle Sam is glad you did pay all you owed. But since the estimate tax process follows the overall U.S. U.S. tax system's pay-as-you-earn approach. That means the estimated tax penalty still applies for each period in which a payment is due.

Forgiven penalties: Although Uncle Sam's tax collector can seem heartless when it comes to getting ahold of your money, the IRS can waive the estimated tax penalty in certain situations.

Some of the more common reasons for IRS estimated tax penalty relief are:

  1. You didn't make a required payment because of a casualty event, disaster, or other unusual circumstance and it would be inequitable to impose the penalty, or
  2. You had no tax liability the previous year and your current tax due is less than $1,000.
  3. You retired (after reaching age 62) or became disabled during the tax year or in the preceding tax year for which you should have made estimated payments and the underpayment was due to reasonable cause and not willful neglect.

Farmers and fishermen also must pay estimated tax, but they face different requirements. IRS Publication 505 has more information about these professions' special estimated tax rules.

Finally, all y'all who live in states with income taxes, don't forget about those jurisdictions' estimated tax requirements. 

The key to paying your estimated taxes is like every other tax situation. Understand your financial and tax circumstances, look at the law and your options, and use the method that works best for you.

A version of this post originally appeared on the ol' blog on Sept. 14, 2015, and was updated on Nov. 1, 2017.

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