Avoiding (and Understanding) the Underpayment Penalty
Like Ben Franklin said, taxes are one of the two things in life that can’t be avoided. While Franklin’s adage definitely applies to most types of taxes, an underpayment penalty is one tax that you can easily eliminate with some quick planning and simple math.
Let’s take a look at how you can take advantage of the IRS’s “safe harbor” rules to make sure you don’t get hit with an underpayment penalty next April.
What is the underpayment penalty?
Uncle Sam (and state governments) prefers to get paid sooner rather than later. That’s why the United States has a pay-as-you-go tax system that requires you to make tax payments throughout the year, not just when you file your tax return the following spring. If you don’t make sufficient payments throughout the year, then you might face an underpayment penalty.
If you get the vast majority of your income from an employer, then you usually don’t have to worry about underpaying. This is because your employer takes care of your payments throughout the year by withholding money from each paycheck.
But if a significant portion of your income comes from self-employment, investments, rental property, or other sources that don’t have withholding, then it is up to you to make estimated quarterly tax payments throughout the year.
Even if you make all of these estimated quarterly payments on time, you could still owe an underpayment penalty if the amount of your quarterly payments is too small relative to your total tax liability for the year.
Finding “safe harbor” from the underpayment penalty
Estimating how much your total tax liability will be for the upcoming year is a difficult task. Fortunately, the IRS provides some “safe harbor” rules that take some of the guesswork out of avoiding an underpayment penalty.
You will not owe an underpayment penalty if your estimated quarterly payments(combined with any amounts withheld by your employer) exceed the following thresholds:
100% of last year’s tax bill (or 110% for high-income taxpayers): If your quarterly estimated payments and withholding equal or exceed your previous year’s total tax liability, you won’t face a penalty. For example, if Steve owed $10,000 in taxes in 2013, he will avoid an underpayment penalty in 2014 if his quarterly estimated payments and withholding during the year total at least $10,000. The threshold increases to 110% for taxpayers with adjusted gross incomes greater than $150,000.
90% of the current year’s tax bill: If your quarterly estimated payments and withholding are at least 90% of what your tax liability is for that year, you won’t face a penalty. For example, if John’s total tax liability for 2014 ends up being $22,000, then he will not owe an underpayment penalty if his quarterly estimated payments and withholding during the year total $20,000 or more.
Within $1,000 of the current year’s tax bill: If your quarterly estimated payments and withholding fall short of your total tax liability for the year but by less than $1,000, then you won’t face the penalty. If Chris’s total tax liability for 2014 ends up being $8,000, then he won’t owe an underpayment penalty if his quarterly estimated payments and withholding during the year total $7,000 or more.
Mind your investment income
Investors and business owners who recognize large capital gains during the year often find themselves subject to an underpayment penalty. In the past two years it has become easier to get hit with an underpayment penalty because of capital gains. The Dow Jones Industrial Average has surged more than 35% since May 2012, and the Affordable Care Act implemented a new 3.8% surtax on capital gains, interest, dividends, and other investment income starting in 2013. If you recognize a large capital gain during the year or have a surge in investment income, then you may need to start making estimated quarterly payments.
Know the “quarterly” schedule for estimated payments
You would probably assume that estimated quarterly payments would be due on regular three-month intervals. You’d be wrong.
The payments for 2014’s estimated taxes are due on:
April 15, 2014
June 16, 2014
September 15, 2014
January 15, 2015
Also, if you are in a business where your income varies significantly from season to season, you might not have to make estimated payments each quarter. For example, if you are a realtor and you did not close any sales during the first three months of the year, you may be able to skip the estimated payment for the first quarter. You will, however, need to explain the seasonal nature of your earnings to the IRS. Your accountant can help you file the proper form with the IRS to explain why you skipped a quarterly payment.
Sitting on cash not worth the risk
Some clients bristle at the prospect of paying estimated quarterly taxes because they don’t want to give the money to the government any sooner than necessary. While deferring tax payments is generally a good rule to follow, it doesn’t make sense when it comes to estimated taxes.
With savings accounts and bonds paying next to nothing, making estimated quarterly payments and avoiding an underpayment penalty is the smartest “investment” you can make between now and April 15.
If you end up slightly overpaying on your estimated payments, that is not a bad outcome. Not only will you have avoided the sticker shock and cash flow problems that can result from a high tax bill in April, but you can also treat your refund as a year-end bonus or—better yet—as a contribution to your personal retirement account.
At Eilts & Associates, we work closely with business owners, investors, and other taxpayers to help them avoid underpayment penalties. If you think you might need to adjust your estimated quarterly payments or withholding in 2014, contact us (773.525.6171 or firstname.lastname@example.org) and we will help you set up a payment schedule that is customized to your specific circumstances.