Tax Payment Planning – Making Timely Payments Will Avoid Penalties
As we move towards the next tax filing season, it’s important to consider what your plan will be for ensuring you pay enough tax this year to avoid an underpayment penalty.
Planning your tax payments is especially important if you have an unusual or unexpected spike in income, like a large bonus from work or a gain from the sale of stock or a piece of real estate. Oftentimes, the first question that pops into your head is “when do I have to pay tax on this income?" The answer might vary, depending on your tax situation. It’s important to understand when the tax liability is due to avoid any underpayment penalties later.
The below discussion is based on Federal tax law. Most states usually follow these rules, but not all do. It’s important to check with your particular state to ensure that you are following their tax payment rules in addition to the Federal rules.
Determining the Amount to be Paid During the Year
Generally, you want to pay as little in tax during the year as you can to avoid an underpayment penalty. The remaining amount owed would simply be paid when you file your tax return. Managing your payments this way allows you to keep the use of your money for the longest period of time. Paying in too much and receiving a refund is simply you giving an interest-free loan to the government.
There are two targets that you can aim for to avoid a penalty, and you can choose the one that allows you to pay in the least amount during the year. The targets are:
- Pay 90% of the current year liability
- Pay 100% of the prior year liability. If your Adjusted Gross Income (AGI) for the prior year was more than $150,000, the required payment percentage increases to 110%.
As long as you meet one of the two above targets, you will avoid the underpayment penalty regardless of how much tax is ultimately due with your tax return. However, if you miss both targets, the IRS will charge interest on the underpayment amount. The interest rate charged is updated quarterly and is currently at 6%, as of the third quarter of 2022. Even though this is an annual interest rate, interest is assessed based on the number of days of underpayment. In other words, your interest penalty is .0164% per day, assuming a 6% annual interest rate, for each day your payment is considered late.
When calculating the amount you need to pay, you have to not only consider income tax, but other taxes like self-employment tax, the tax on net investment income, Alternative Minimum Tax, penalties on required account withdrawals, etc.
If you choose to base your tax payments of your prior year’s tax liability, you know exactly what number you need to hit. Because of that, it is sometimes referred to as the “safe harbor” amount. Using this method, it doesn’t matter what you end up owing on your tax return. As long as your payments exceed last year’s tax liability, there will be no penalty. This strategy is usually optimal if you expect your current year’s tax liability to be more than what it was in the prior year.
On the other hand, if you expect your current year’s tax liability to be the same or less than the prior year’s liability, you may want to target 90% of the current year’s liability to minimize the amount that needs to be paid during the year. Because you have to estimate your current year’s tax liability, you may want to add a bit of a buffer, say 3-5%, on top of the 90% estimate to provide a cushion for any unexpected income that might come in during the year.
When Should you Make your Tax Payments?
While you will have some flexibility in calculating the amount of tax you must pay in during the year, you do not have much flexibility in determining the timing of when those payments must be made. Typically, you can’t just wait until the end of the year to make all your tax payments. The targeted amount must be paid on a quarterly basis or else you could end up underpaying. The required quarterly payment to avoid a penalty is simply ¼ of the total requirement for the year. The payment due dates for each quarter are April 15, June 15, September 15 and January 15. Those deadlines are pushed out if any of those days fall on a weekend or holiday.
How do you Make your Tax Payments? Withholding or Estimated Tax Payments?
If you’re working, you are required to have taxes withheld directly from your salary. If you have little to no income beyond your salary, that withholding is usually enough to cover your targeted tax payment. If you receive a larger bonus, have stock option income, etc. where only a fixed percentage of that payment is withheld, the amount withheld may not be enough to cover the resulting tax liability.
If you have income that is not required to be withheld on, like investment income, business income, retirement account distributions, Social Security, etc., you may need to make additional tax payments throughout the year. These estimated payments are due at the quarterly deadlines mentioned earlier. If you miss a payment, don’t wait until the next payment due date to make that payment. The interest penalty is calculated daily, so making the payment as soon as possible will minimize the amount of the penalty.
What if you Have an Unexpected Increase in Income?
Perhaps you sold a piece of real estate, a business or investment in your portfolio that resulted in a large capital gain or you receive a larger-than-expected bonus at work. What is your obligation in regard to making a tax payment? The answer—it depends!
Your options in the above scenario are:
- Do nothing. If your projected tax payments will meet or exceed 100% of your prior year’s tax liability (110% if last year’s AGI was over $150,000), no additional payments are required. You may owe a (relatively large) payment when you file your return, but no underpayment penalty would be assessed.
- Increase withholding on your wages, pension, Social Security or other sources of income that you are able to withhold on.
- Make a separate, estimated tax payment to get you back on target to meet 90% of your current year’s tax liability. Most of the time, that payment will need to be made in the quarter that the income was earned.
In the year you receive the unexpected increase in income, you can usually rely on the safe harbor amount to easily pay in the proper amount during the year. In the year after the increase in income, tax planning becomes more important. Now, you will most likely want to target 90% of your current year’s tax liability, assuming you don’t expect a spike in income again. This will require you to accurately estimate your current year’s tax liability and be diligent to update that estimate for any changes that may occur during the year.
Tax Payment Tips
If you find yourself behind on tax payments during the year, you may find it more prudent to increase your withholding versus making an estimated tax payment. Withholding is considered to occur evenly throughout the year (just like your income). Estimated payments are only credited towards the quarter they are made. If you realize that you’re behind as the end of the year is approaching, you could increase your withholding over the last few months of the year. The IRS will assume that those payments were made evenly throughout the year, avoiding an underpayment penalty. Simply making a single estimated tax payment may not accomplish this.
Using a technique called “Annualized Income” could be used to reduce the risk of an underpayment penalty. It can be especially helpful if you make your tax payments using estimated payments. Annualized Income determines your estimated tax liability as your income accumulates throughout the year instead of dividing your entire year’s estimated tax liability by four, as if your income was earned evenly. This technique can be particularly effective if your income tends to come later in the year. For example, if you’re a business owner whose income is irregular, an investor who realizes gains later in the year or a retiree who takes their required minimum distributions at year-end, the Annualized Income technique could be for you.
Where Can You Get Help with Tax Payment Planning?
The IRS provides a calculator that you can use to project your current year’s tax liability and compare it to your estimated tax withholding. It will also help you complete a W-4 if your withholding is not projected to cover enough of your projected tax liability. That calculator can be found here: https://www.irs.gov/individuals/tax-withholding-estimator.
Contact your Financial Planner at Shakespeare Wealth Management to discuss your expected income for this year. We can run projections and help you estimate your tax liability. We can also work in conjunction with your accountant to ensure an appropriate plan is put in place.
You can also work directly with your accountant early in the year to estimate next year’s income and project the resulting tax liability. Your accountant can also help you come up with a tax payment plan.