Do I really need to give the IRS more money after April 15?
What a relief it is as individual taxpayers to get our income tax returns filed by April 15th (or sometime thereafter, on extension) and have the IRS leave us alone for another year, right? Well – maybe, depending on your income and income tax withholding on said income. If your withholding doesn’t keep pace with what the IRS requires, you may be required to make quarterly estimated tax payments throughout the tax year. You may already be experienced with how the IRS rules work regarding these payments, but here is some additional explanation if you are not entirely clear, or if you need a refresher.
When you file your income tax return, the IRS (and your preparer’s tax software) will determine whether you owe a penalty for underpayment of estimated taxes. To comply with the law and avoid the penalty, your tax must have been paid throughout the year such that:
- You owe less than $1,000 with your tax return, or
- 90% of total current year tax, as shown on your current year’s tax return, was paid during the year, or
- 100% of your prior year’s tax (110% if your prior year’s adjusted gross income was over $150,000 if married filing jointly or $75,000 if single or filing separately) was paid during the year.
Tax planning opportunity: Which of these three approaches will keep more money in your pocket and less in the pocket of the IRS for as long as possible? You comply with the law by paying the least of these three options.
“Paid” means money has been sent to the IRS in the form of either withholding or estimated tax payments, or both. If you have had tax withheld on any wages, IRA or pension distributions, etc., this qualifies as “paid.” If your withholding covers you for the requirements above, you do not have to make estimated tax payments.
“Throughout the year” normally means that the IRS expects to have received one-quarter of the required tax “paid” on or before each of the following dates: April 15, June 15, September 15, and January 15 of the following year. In other words, making one large estimated tax payment late in the year will not satisfy the requirement to make the payments in a timely manner.
Tax planning opportunity: The IRS treats withholding as if it has been paid in quarterly, even if the withholding takes place on December 31. Accordingly, if you have a large year-end payment coming to you from a bonus or other source, with planning you can satisfy the rules by having some or all required tax withheld from that year-end payment.
So, which of the three approaches above is best? In general, if your taxable income stays about the same or is expected to increase from one year to the next, you can avoid penalties by following rule number (3). A typical approach (commonly referred to as “safe harbor”) is to review your prior year tax amount, see which AGI percentage applies (100% or 110%), take current year withholding into account, and pay the remaining estimated tax liability over the four required quarters. (Please note: if your current year withholding has changed or will change significantly, you will need to take that into consideration.) Following this approach, you are covered against penalties even if current year income increases significantly; you’ll still owe tax with the filing of your return, but you’ll be covered against the estimated tax penalty if you’ve paid in the required amount based on your prior year AGI and tax.
If your current year income is expected to decrease significantly, approach (2) is probably your best bet, although it requires making assumptions and estimating your tax due for the year. If your income ends up being higher than expected, however, you may be underpaid for earlier quarters and owe some penalty. There is an alternative way to compute the required timing of your payments called the “annualization” method if your receipt of income fluctuates significantly during the year. This method requires additional time and math but can be helpful if you have a significant income event late in the year.
If you fail to make the required annual payment, what is the penalty? Essentially, the IRS charges you interest (which is not compounded) for the period(s) in which you failed to pay the tax. For instance, if you forgot to make your April 15 estimated tax payment, and made that payment on August 31, the IRS would charge you a “penalty” consisting of the interest computed for the 138 days your payment was late. If the payment was not made until April 15 of the following year, the interest would be computed for 365 days. The interest rate used by the IRS changes quarterly. Economic factors will determine what each quarterly rate will be.
From time to time, we have prepared returns for taxpayers who have money invested which earns a higher return than the IRS penalty rate, and those taxpayers might choose to not make estimated tax payments. The logic is that it makes more financial sense to leave the money invested and pay the resulting penalty when the taxpayer files his or her income tax return.
Two additional points relating to estimated taxes should be considered:
- Depending on your state of residence, you may be required to make state estimated income tax payments as well. In past years, it was generally beneficial for taxpayers to pay their fourth quarter state estimate before December 31, so that it could be taken as a current year federal Schedule A deduction. However, the Tax Cuts and Jobs Act continues to limit the deduction for state and local income and property taxes to $10,000, thereby eroding the benefit of making the payment early in many situations.
Tax planning opportunity: Should I pay my state estimate early? The deduction limit must be considered for your own specific situation.
- You may be fully in compliance with the estimated tax rules, avoiding any penalty for underpayment of estimated tax, but still have a substantial tax liability to be paid on or before April 15th, depending how your income and deductions end up for the year. You may want to consult your tax advisor in November or December to avoid an unpleasant “April surprise.” Remember, even if your tax return is extended automatically to October 15th, all tax must be paid in full by April 15th to avoid additional penalties and interest.
If you have additional questions or we at Parsec Tax Services can be of assistance in any way, please do not hesitate to contact us or your Parsec advisor.