We can all agree that nobody likes a hefty tax bill when they file their tax return.
An important way we can mitigate our tax liabilities is by engaging in tax-focused financial planning to help us take advantage of various deductions, tax credits, and tax-deferral strategies that lower the total amount we owe federal, state, and local governments. Sometimes those techniques lower our current year taxes and other times they lower our lifetime tax bill. They may even reduce the taxes due from the next generation who may inherit our wealth.
Even with the best planning, there is only so much we can do to reduce the amount of taxes we owe. While it doesn’t ultimately reduce our current year's taxes, we can further mitigate costs by ensuring we are paying enough toward the tax we owe in a timely manner. Paying less than we should or not paying on time can lead to underpayment penalties.
An underpayment penalty is an additional cost you pay at tax time based on the amount you underpaid. When interest rates were low, the underpayment penalty was about 3% but now that rates have increased, so has the penalty. It currently stands at 8% of the amount you underpaid, meaning the cost of untimely payments has more than doubled.
To understand how to avoid this cost, we need to understand a few terms:
Tax Bill – the amount of tax we owe, which is determined by completing our tax return
Tax Withholding – the amount others send in on our behalves throughout the year to go toward our tax bill, usually withheld from our paycheck, pension, Social Security or retirement plan withdrawals
Estimated Tax Payments – the amount of money we send in ourselves on a quarterly basis to go toward our tax bill
Tax Due – the amount we pay when we file our tax return if our tax bill is higher than the total of our tax withholding and estimated tax payments (if we paid in more than our tax bill, we get a tax refund)
Governments need income throughout the year, so they require taxpayers to make tax payments on income as it is earned. We typically can’t earn income and simply wait to pay the tax due until we file our return; doing that is how we incur an underpayment penalty.
Specifically, we need to pay enough to meet the safe harbor rules. These rules state that to avoid an underpayment penalty, we must pay either
90% of our current year tax due or
100% of our prior year tax due
Note that if our adjusted gross income from last year exceeds $75k as a single person or $150k as a married couple, we have to pay either 90% of our current year's tax or 110% of our prior year's tax to be safe.
Now that we know the amount we have to target to be safe from penalties, we need to consider the timing of when to make these payments. The timing requirements are different depending on whether you pay your tax by withholding or if you pay tax with estimated payments.
Paying tax through withholding gives us the most flexibility on timing. If our tax bill for the year is $10,000 and we need to pay $9,000 to be safe from penalties, we can withhold that $9,000 at any time during the year. It can be withheld on January 1st or December 31st or any combination of days in between. As long as we withhold the right amount by year-end, we will avoid underpayment penalties.
Estimated tax payments are trickier. These payments are due quarterly on April 15, June 15, September 15, and January 15 of the following year. Let’s still assume our tax bill is $10,000 and we need to pay $9,000 to be safe. We now need to consider when we earned the income that incurred the $10,000 tax.
One taxpayer may have earned a consistent income all through the year, in which case, they would make even estimated tax payments of $2,250 in April, June, September, and January to get their $9,000 paid on time. When they file their return, they will owe the remaining $1,000 with no penalties.
Another taxpayer may have had one big job in May which generated their entire income for the year. May is part of the second quarter, so the $9,000 tax on this income needs to be paid with the second quarter tax payment in June. They would not need to make any payments in April, September, or January but they will owe the remaining $1,000 of tax when they file their return the following year.
Understanding these rules can help us avoid common traps and take advantage of opportunities.
A common trap many of us fall into is assuming our employer is withholding the right amount of tax for us. Employers withhold tax based on how we fill out our W-4. If we claim too many exemptions, they might not withhold enough tax for us, resulting in owing money with our return and potentially owing a penalty.
Another common trap occurs for employees with bonuses or incentive compensation such as stock options or restricted stock units. While our employer may withhold tax on this income, they may withhold a flat rate which is less than the amount of tax we owe. For instance, if we are in the 35% tax bracket but our employer only withholds 25% tax on stock options, that leaves a 10% underpayment on that income that might lead to penalties. In this case, we would likely need to make an estimated tax payment to supplement the tax withholding from our payroll.
Lastly, understanding safe harbor rules helps us avoid overpaying the government. By understanding that we only need to pay $9,000 of our $10,000 tax bill in advance, we can hold on to the remaining $1,000 until we file our tax returns. In the meantime, the $1,000 can be earning interest in our bank accounts, which is especially beneficial in today’s higher-rate environment.
Several tools exist to help us estimate our tax bill, including one provided by the IRS. Tax professionals and financial planners can also help. No matter how you figure it, it is worth aligning our tax payments with our current year's tax, especially in light of the higher underpayment penalties currently in effect.
As originally published on Forbes: