When it comes to estimated tax payments, there are problems you will want to avoid. In fact, there are three potential penalties that can rear their ugly heads with the filing of your tax returns. This includes 1) Failure to file, 2) failure to pay, and 3) underpayment of estimated tax. This post will discuss the underpayment of estimated tax penalty.
We normally prepare estimated tax payments where required for clients. We also will often receive the question “do we have to pay these estimates?” if the client is not used to seeing these estimated tax vouchers with their tax returns they are normally confused or surprised.
If a taxpayer owes more than $1,000 with the filing of their tax return, they more than likely should have paid estimated tax payments on a quarterly basis, and if they did not, they might be subject to the underpayment of estimated tax penalties. This penalty is calculated like interest at the stated underpayment interest rate that is adjusted by the IRS at regular intervals. The theory here is that you had the use of that money during the year, rather than the Internal Revenue Service.
There are two methods whereby a taxpayer can figure his or her estimated tax payments. There is a “safe harbor” method whereby the taxpayer can pay in 100% (110% if their income is over a certain level) of his or her amounts as shown on their previous year’s tax return. If they pay in these amounts they would not be subject to penalties no matter how high their current year income ends up being.
An alternative method is that they could figure and pay in 90% of their projected current year liability. The challenge with this method is the word projected. Normally most taxpayers do not have a handle on how much their current year income is, and/or it is quite burdensome to calculate.
The first method is most beneficial for taxpayer’s whose income is greater in the current year over their prior year liability. This method allows them to keep more money in their pocket during the year. The downfall with this method is that the taxpayer might have a rather large “balloon” payment due come April 15th. The second method is best for clients that have decreased incomes in the current year over the prior year. This would allow less amounts to be remitted due to decreased incomes.
A lot of taxpayers ask if these estimates are really “required”. They believe that if they do not make these payments the IRS will come knocking down their door looking for these payments each quarter. This is not the case. However, I would answer that they are definitely required and the effect of not paying them timely is that the taxpayer would be subject to the penalties mentioned above when they go to file their tax returns come April 15th.
If the taxpayer is an employee but happens to be under withheld, we would suggest that withholdings are increased in order to cover this shortfall. A lot of times being under withheld is caused by a two-earner household. This is due to the fact that each spouse reports their withholding amounts to their employer’s based on their withholdings but when combined with their spouses on their year end tax return the tax rate is higher due to the combination of their incomes. This difference is exacerbated the more each spouse makes.