3 ways to navigate estimated tax penalty safe harbors
Monday, September 14, 2015
NOTE: This post was updated Wednesday, Nov. 1, 2017
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 penalty is calculated based on the interest rate charged by the IRS on unpaid tax. In 2015, the average estimated tax penalty was about $130.
The IRS says it's 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.
Even when individuals know they must file estimated taxes, the process of getting the amount correct can be confusing.
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 where just one spouse a job with withholding and the other's earnings are from self-employment income as long as the couple files a joint return.
But if you don't have the withholding income option, here are three other ways to avoid the estimated tax penalty.
Four extra filings: Estimated tax payments are required when you get income that isn't subject to withholding. This could be income as an independent contractor, investment earnings, prize money or certain gambling winnings.
Basically, Uncle Sam expects you to take out the amount he should get and send it to him four times a year. They 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. If you mail it in, 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.
Note the table's information for payment #3. It's due tomorrow, Tuesday, Sept. 15.
When figuring your estimated tax amount, be careful. If you miscalculate, when you file your annual tax return you'll discover that in addition to the taxes due, you'll owe interest on any amount you should have paid, along with a penalty for underpayment.
The good thing is that Uncle Sam offers all of us trying to navigate treacherous estimated tax waters three safe harbors that can protect us from penalties.
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.
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, the 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.
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.
Trickier, more elaborate annualized method: Of course, it takes also requires more work and record keeping.
You have to file Form 2210, Underpayment 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.
The penalty still applies even if you ended up paying your full estimated tax amount by making up the one quarter's shortage by paying more in another quarter.
Finally, farmers and fishermen face different estimated tax requirements. IRS Publication 505 has more information about these professions' special estimated tax rules.
And for all y'all who live in states with income taxes, don't forget about those jurisdiction's 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.
You also might find these items of interest:
- IRS Direct Pay one of many ways to pay estimated taxes
- Amounts you'll need to calculate your estimated tax payments
- Be sure to include self-employment taxes in 1040ES calculations
April is a great time of year for so many people who look forward to their tax refund. People plan around that cash because they have looking forward to getting it back all year long.
Posted by: Sarah | Thursday, October 08, 2015 at 12:10 PM