What a relief it is as individual taxpayers to get our pesky income tax return filed on April 15 (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 need a refresher.
When you file your 2019 income tax return in April of 2020, the computers at the IRS (and your preparer’s tax software) will digest the numbers you have provided and determine whether or not you owe any penalties for underpayment of 2019 estimated taxes. To comply with the law and avoid these penalties, your tax has to have been paid throughout the year such that:
- You owe less than $1,000 with your 2019 tax return, or
- 90% of total 2019 tax, as shown on your 2019 tax return, was paid during 2019, or
- 100% of your total 2018 tax (110% if your 2018 adjusted gross income was over $150,000 if married filing jointly or $75,000 if single or filing separately) was paid during 2019
[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 are in compliance 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. So, 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” means that the IRS expects to have received one-quarter of the required 2019 tax “paid” on or before each of the following dates: April 15, June 15, and September 15, 2019 and lastly January 15, 2020. In other words, making one large estimated tax payment late in the year will not satisfy the IRS that you have made 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 might be best? In general, if your taxable income stays about the same or is expected to increase from 2018 to 2019, you can avoid penalties by following rule number (3). A typical approach is to consider your 2018 tax amount, see what percentage applies (100% or 110%), take withholding into account, and pay the remaining estimated liability over the four required quarters. (Please note: if your withholding will change significantly, you will need to take that into consideration.) Following this approach, you are covered against penalties even if you win the lottery and your 2019 income skyrockets; you’ll still owe a big tax bill eventually, but you’ll be covered against estimated tax penalties if you’ve paid in the required amount based on your 2018 information.
If your income is expected to decrease significantly, approach (2) probably is 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 calculation, but can be helpful if you have a significant income event late in the year.
If you fall afoul of these rules, what is the penalty? Essentially, the IRS charges you interest (which is not compounded) for the period(s) in which you should have paid them tax, but did not. For instance, if you forgot to make your April 15 estimated tax payment and made that payment on May 31 instead, the IRS would charge you a “penalty” consisting of the interest computed for the 46 days your payment was late. If the payment was not made until April 15, 2020, the interest would be computed for a full year. The interest rate used by the IRS changes quarterly. For the first six months of 2019, the rate was 6%; for the third quarter of 2019, the rate decreased to 5%. Economic factors will determine what the fourth quarter rate will be. Thus, this penalty is generally less punishing than other IRS penalties such as those resulting from failing to file a return in a timely manner or late payment of tax due with the return.
From time-to-time I have prepared tax returns for some taxpayers who have money invested which is earning a higher return than the IRS penalty rate and choose to not make estimated tax payments. Their thinking is that they would rather leave their money invested, not make quarterly payments, and pay the resulting penalty when they file their income tax return. Although this strategy cannot be generally recommended, there is some sense to this reasoning.
Two additional related points should be taken into account:
- 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 true that the fourth quarter estimate for state income taxes would be paid before December 31 so that it could be taken as a deduction, claimed for the year of payment. However, since the tax act applicable for 2018 and later years limits the deduction for income and property taxes to $10,000, paying this estimate early might not provide any tax benefit at all. [Tax planning opportunity – should I pay my state estimate early? The deduction limit has to 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 15, 2020, depending how your income and deductions ended up for 2019. You may want to consult your tax advisor in November or December to avoid an unpleasant “April surprise.” Remember, even if your 2019 tax return is extended automatically to October 2020, all 2019 tax must be paid in full by April 15, 2020 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.
Brad Burlingham, CPA
Director of Tax Services