Martin S. Kaplan, CPA, New York City. He is a frequent guest speaker at insurance, banking and financial-planning seminars and author of What the IRS Doesn’t Want You to Know (Wiley).
One of your first tax moves of 2008 should be to adjust the amount of income tax that you pay through wage withholding and/or quarterly estimated payments made during the year.
If you simply pay the same amount that you did last year, changes in your financial situation can lead you to pay…
Too much tax, and make an interest-free loan to the government.
Too little tax, and owe interest and underpayment penalties.
The IRS charges interest on tax underpayments (currently at a 7% rate, adjusted quarterly) and an underpayment penalty of 0.5% per month (up to a maximum of 25%). Interest and penalties run from the date of any underpayment.
The IRS generally does not pay interest on overpayments that a taxpayer makes during the year and that are refunded on a tax return. It pays interest only if a refund is held up and paid 45 days or more after a return is filed.
Since you don’t get interest on a tax overpayment, you shouldn’t want to overpay your taxes — a large tax refund costs you money.
Here are rules you need to know, and how to find the right amount of tax to pay throughout the year…
Personal tax payments are made during the year in two forms…
Income tax wage withholding subtracted from your salary by your employer.
Estimated tax payments that you remit to the IRS using Form 1040-ES, Estimated Tax Payment Voucher, to cover taxes due on nonwage income (such as self-employment income, distributions from trusts and retirement accounts, wagering winnings, etc.).
Estimated tax payments are commonly described as “quarterly,” but tax payment periods are not exact calendar quarters. For the “quarter”…
January 1 to March 31, payment is due April 15.
April 1 to May 31, payment is due June 15.
June 1 to August 31, payment is due September 15.
September 1 to December 31, payment is due January 15 of next year.
There are two ways to determine the amount of estimated tax due in each payment to avoid penalty…
25% method. Each payment is at least 25% of the total estimated tax that you will finally owe for the year.
Annualization method. For each period listed above, make a payment that brings your total estimated tax payments for the year to an amount sufficient to cover the tax due on income received through that period, projected on an annual basis.
Example: Say you are single and…
Your taxable income through the first quarter is $20,000. Multiplied by four, that’s $80,000, on which you would owe about $16,000 in tax, based on the tax tables for 2008 returns. Your payment for the first quarter is one-quarter of that $16,000, or $4,000.
Your taxable income through the second quarter (ending May 31) is $50,000. Multiplied by two, that’s $100,000, on which you would owe about $22,000 of tax. Your payment for the second quarter should be enough so that when added to your payment for the first quarter, the total is half of that $22,000, or $11,000. So if your first-quarter payment was $4,000, your second-quarter payment should be $7,000.
Strategy: The 25% method is the simplest, but annualization reduces the tax that you owe for early quarters if income increases later in the year.
Example: Say that you will owe $100,000 of estimated tax for the year, after receiving 10% of your total income in each of the first three quarters and 70% of it in the fourth quarter. Using the…
25% method, you must pay $25,000 of tax each quarter.
Annualization method, you pay only $10,000 of tax in each of the first three quarters and $70,000 for the fourth. This saves you from paying tax on your late-in-the-year income before you receive it.
It’s possible to pay during the year less than the final amount of tax that you will owe for it, without being penalized. (If the amount you owe is less than $1,000, there is no penalty.) To avoid penalty, your combined withheld and estimated tax payments made during the year must equal at least one of these “safe harbor” amounts…
100% of your previous year’s tax liability — 110% if your previous year’s adjusted gross income (AGI) exceeded $150,000. Use this method if your income rises sharply from the prior year.
Example: In 2007, you owed $20,000 of income tax (on AGI of less than $150,000) and in 2008, you expect to owe more. You need pay only $20,000 through wage withholding and estimated taxes in 2008, and can make up the difference, no matter how big, without penalty when you file your return.
90% of the tax liability you finally owe for the year. Use this option if the tax you will owe this year will be about the same as or lower than last year’s.
Example: In 2007, you owed $30,000 of income tax and will owe $20,000 in 2008. Your tax payments during the year need be only $18,000, and you can make up the difference of $2,000 without penalty when you file your return.
Trap for estimated taxes: Even if you pay a safe harbor amount — in fact, even if you overpay your taxes by year-end — you can still owe estimated tax penalties and interest for underpayments in early quarters of the year.
Example: You neglect to make any estimated tax payment for the first quarter. During the rest of the year, you more than make up this shortfall, overpaying your taxes to the point that you are entitled to a refund when you file your return. You will incur an underpayment penalty and interest for the first quarter that will be subtracted from your refund.
Wage withholding can be increased to cover more than the tax owed on salary — to pay tax due on nonwage income as well. This can help avoid underpayment penalties on both withheld and estimated taxes, even retroactively!
Loophole: Wage withholding is treated by the IRS as if it were paid at an equal rate (25% each quarter) even when it’s increased late in the year.
Thus, if taxes are underpaid in the early part of the year, increasing wage withholding from late-in-the-year paychecks to make up the shortfall can retroactively eliminate penalties and interest due from the early quarters.
Caution: The IRS warns taxpayers not to abuse this rule by intentionally underpaying taxes throughout the year and then paying them through last-minute withholding. It may impose steep penalties if it suspects this behavior.
Withholding is also much simpler than computing and making your own estimated tax payments, reducing the chance of making costly mistakes.
How to do it: Figure your best amount to withhold in 2008 by using the worksheet in Form W-4, Employee’s Withholding Allowance Certificate, supplied by your employer, or the “IRS Withholding Calculator,” in the “Individuals” section at www.irs.gov.
Compute best-sized estimated tax payments using the worksheet in Publication 505, Tax Withholding and Estimated Tax.
When doing so, remember to consider the effects of events that you expect to occur later in the year that will affect your tax bill for the entire year — such as marriage or divorce, taking a large investment gain or loss, or making a large deductible business investment. Why…
A tax-reducing event can let you reduce your tax payments from the beginning of the year.
A tax-increasing event may lead you to choose to increase tax payments modestly from the beginning of the year to avoid a big increase in tax payments late in the year.