by Brett Norris, CFP®
Vice President
Wealth Planning
As April 15 draws closer, individuals across the country are filing their tax returns, some of whom are anxiously awaiting the results. In addition to the pressures of having to track down a year’s worth of transactions and tax information, many taxpayers experience further stress related to the uncertainty of facing additional taxes. Will they owe the IRS, or will the IRS owe them? Worse yet, might they have gotten it so wrong that they’ll be penalized—required to pay more than what’s simply owed? In most cases, the results shouldn’t be a mystery. Demystification starts with understanding some basic tenets of the tax system and its standard operating procedures.
Taxes in the U.S. are generally considered to be “pay-as-you-go,” meaning taxpayers are expected to remit tax as they receive income. This is typically accomplished in one of two ways:
Withholding tax from income received (i.e., employment wages, pension payments, Social Security benefits, etc.); or,
Making quarterly estimated payments throughout the year (generally applicable to individuals who receive income from dividends, interest, capital gains, or other sources where there are no withholdings).
Understanding this methodology is important, but largely unhelpful if the taxpayer is unclear on how much they should be paying. Accountants may work with their clients to estimate the liability based on expected income and prescribe what payments should be made throughout the year. The IRS also provides a free tax withholding estimator tool for those who would like to evaluate how much federal income tax should be withheld from their paycheck. Any shortfall (total tax liability less withholding) may need to be remitted in estimated taxes.
Quarterly Estimated Payments
Taxpayers who are required to pay estimated taxes must do so quarterly. To determine what amount should be paid each quarter, one of the following two methods may be employed:
Regular Installment Method.: Simply divide the total amount of required estimated payments by four and remit that amount on each due date. This method is commonly used and ideal for taxpayers with consistent income.
Annualized Income Method.: Taxpayers can recast their payments, so they correlate to when income is received (and cash is available to make payments). This method is ideal for taxpayers whose income is difficult to predict and/or fluctuates throughout the year.
Safe Harbor Provisions
Despite best efforts, estimate calculations are inherently imprecise. Thankfully, taxpayers don’t need to be perfect to avoid underpayment penalties. There are “safe harbor” provisions that restrict penalties from being imposed on taxpayers who fail to wholly satisfy their obligations, if one of the following conditions are met:
They paid, through withholdings and/or estimates, at least 90% of their current year’s tax liability; or,
100% of the preceding year’s obligation (110% for taxpayers with an adjusted gross income equal to or exceeding $150,000); or,
their federal tax liability is less than $1,000.
Considerations for Liquidity Events
Safe harbor rules are especially useful for individuals who incur income from a unique occurrence such as the sale of a business, equity compensation award, or another unexpected windfall. Although welcome, these types of events may create confusion in terms of when and how the resulting taxes should be paid. Taxes undoubtedly must be paid, but the recipient may choose to continue making their scheduled estimated payments (based on 100%, or 110% of their previous year’s liability) to avoid penalty, no matter their current year’s obligation.
This technique may be advisable in the case of a business sale, for example, as it allows the seller to retain their gross proceeds until they file their return, rather than paying the corresponding tax as part of an estimate soon after the transaction. With professional guidance, the portion of the proceeds allocable to taxes may be invested in a short-term strategy designed to generate income in the period between receipt of the proceeds and when the taxes are due.
Underpayment Penalties
Taxpayers should consult with their accountant and professional advisors in implementing advanced techniques, as the consequences of underpaying could be significant. Penalty amounts vary but are generally based on a combination of the underpayment amount, the period in which it occurred, and the prevailing interest rate at the time. The penalty for underpaying estimated tax is calculated separately for each quarter, meaning a penalty may be imposed relating to a specific quarter’s underpayment, even if the shortfall were rectified in subsequent payments within a single tax year. For example, it is possible for a taxpayer to be owed a refund at year-end for overpayment, yet still be subject to an underpayment penalty for the first quarter.
Avoiding Underpayment Penalties by Withholding
Unlike quarterly estimated payments, taxes withheld directly from income are deemed to have been paid evenly throughout the year, regardless of when the withholding occurred. This presents an opportunity for taxpayers who find themselves underpaid as they approach year-end. In certain cases, an individual may choose to increase their withholdings in the latter part of the year (such as with a year-end bonus), so that it may be considered as paid evenly throughout the year.
Retirees with no earned income may use distributions from their IRA (Individual Retirement Account) to accomplish the same goal by using the 60-day tax-free rollover rule to their advantage. Here, a taxpayer may initiate a distribution from their IRA and have up to 100% of it withheld for taxes (which will be considered as having been paid evenly throughout the year). The taxpayer would then redeposit the funds into their IRA within 60 days so that the initial disbursement qualifies as a tax-free rollover. There are limitations and rules to the 60-day rollover technique; but when done properly, the transaction will not generate any income tax for the taxpayer, nor will they be penalized for the distribution. If they had made a payment to the IRS directly from their checking account in the same scenario, they may be subject to an underpayment penalty for the preceding quarter(s), despite having fully satisfied their outstanding tax obligation.
Be Cautiously Confident
Despite its idiosyncrasies, taxpayers should not fear the U.S. tax system. For most, the process of paying and filing is straightforward. Even those who find themselves in complicated circumstances should rest easy knowing there are rules and strategies designed to make the process less challenging. That said, it is important for all taxpayers to be cognizant of their tax circumstances and, when necessary, seek the counsel of professional advisors to ensure adherence to applicable rules and regulations. In many cases, working with a professional accountant or other advisors can lead to greater efficiency in overall tax strategy.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. We believe the information provided is from reliable sources but should not be assumed accurate or complete. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.