Underestimated Tax Payments

One of the items that I look at when I review an income tax return for our clients is whether the taxpayer was assessed an underpayment penalty. I have discovered that a lot of clients are not aware of how much these rates have increased and what they can do to reduce the penalty. Hopefully, the following will be helpful to you if you are subject to paying estimated income tax penalties.

First and foremost, remember that the payment of income taxes is a concept of “pay as you go” method. This refers to the system where taxpayers are required to pay their income taxes throughout the year as they earn income, rather than paying the entire amount owed at the end of the tax year.

The Internal Revenue Service imposes penalties for underpaying estimated income taxes throughout the year. These penalties, known as the “estimated tax penalty” or “underpayment penalty,” are calculated separately for each quarter based on the amount of unpaid tax for that period.

How the Penalty is Calculated:

The penalty equals the federal short-term interest rate (in the first month of the quarter in which taxes were not paid) plus 3 percent. As of mid-2024, the estimated tax penalty has reached a whopping 8% – the highest it has been since 2007. This penalty is not deductible, so the effective rate is even higher.

Avoiding the Penalty:

To avoid the underpayment penalty, individuals with an adjusted gross income (AGI) of $150,000 or less must pay by the due date of the tax return the lesser of:

1. 90% of the current year’s tax liability (paid through withholdings or timely quarterly estimates)
2. 100% of the previous year’s tax liability

For those with an AGI above $150,000, the threshold is higher at 110% of the previous year’s tax liability. These amounts can be paid through a combination of withholding from paychecks and timely quarterly estimated tax payments.

It’s important to note that meeting the safe harbor requirement (either 100% or 110% of the previous year’s tax liability) guarantees avoidance of underpayment penalties, regardless of your actual tax liability for the current year. However, if you expect your income to decrease, you may choose to pay 90% of your estimated current year tax liability instead, though this carries more risk of penalties if your estimate is too low

Safe Harbor Rules

The IRS provides “safe harbor” rules that allow taxpayers to avoid the penalty if certain conditions are met, such as:

• Owing less than $1,000 in taxes (This is not after estimated or withheld taxes, it is the total tax owed)
• Paying at least 90% of the current year’s tax liability through withholdings and timely estimated payments

Notice that taxes withheld from wages & other sources are treated as if they were withheld equally over the year.

• • Withholding a large amount from an IRA distribution towards the end of the year does gives you credit for tax payments as if you made them equally throughout the year.
  • When you take a taxable distribution from your traditional IRA, you have the option to have federal income tax withheld from the distribution amount. The default withholding rate is 10%, but you can elect to have a different percentage withheld using IRS Form W-4R. The withheld amount is credited against your total tax liability when you file your tax return for that year.
  • However, the timing of the withholding does not affect how the payment is credited. Whether you withhold the entire amount in December or spread it out evenly throughout the year, the total withheld will be treated the same way – as a prepayment towards your tax liability for that year. There is no advantage or credit given for making withholding payments earlier in the year.
  • The IRS does not consider when the withholding occurred – only the total amount withheld for the tax year. If too little tax is withheld compared to your actual tax liability, you may owe additional taxes plus potential underpayment penalties when you file your return.
  • So in summary, while withholding from an IRA distribution can help cover your tax liability, the timing of when that withholding occurs within the tax year is irrelevant. The total amount withheld is simply credited as a prepayment when you file, regardless of whether it was withheld upfront or at the last minute

Quarterly Payment Deadlines

For those required to make estimated tax payments (e.g., self-employed individuals, business owners), the quarterly deadlines are typically:

• April 15
• June 15
• September 15
• January 15

However, these dates may be adjusted if they fall on a weekend or holiday. By understanding the estimated tax penalty rules and making timely payments through withholding or estimated payments, taxpayers can minimize or eliminate this costly penalty.

One effective way to minimize or avoid the estimated tax penalty is to use the annualized income installment method. This method allows you to pay estimated taxes based on your actual income earned during each period of the year, rather than having to project your entire year’s income upfront.

The annualized income installment method divides the tax year into four payment periods, with each period using a different income annualization factor:

1. Period 1 (Jan 1 – Mar 31): Annualize income for this period by multiplying by 4
2. Period 2 (Jan 1 – May 31): Annualize by multiplying by 2.4
3. Period 3 (Jan 1 – Aug 31): Annualize by multiplying by 1.5
4. Period 4 (Jan 1 – Dec 31): No annualization needed for full year

By annualizing your income for each period based on the actual amounts earned, you can make more accurate estimated tax payments that reflect your cash flow. This reduces the likelihood of underpaying and being subject to penalties.

To use this method, you need to complete IRS Form 2210 (Underpayment of Estimated Tax by Individuals) and attach it to your tax return. Be sure to check Box C for “Annualized Income Installment Method” under Part I.

While the annualized method involves more calculations, it provides flexibility for those with fluctuating or seasonal incomes. It ensures you pay the proper estimated taxes based on what you’ve actually earned, rather than an upfront projection.

So, if your income varies significantly throughout the year, strongly consider using the annualized income installment method. It can save you from costly underpayment penalties by aligning your estimated tax payments with your actual earnings pattern.

If you have your tax return prepared by a tax practitioner, be sure to provide them with the information that they will need to use this method. They can determine the amounts from the sale of assets where they have the dates sold. However, for income that you receive a 1099 for, you will have to provide the dates received to them.

Article by:  Lewis Robinson, CPA

To further discuss this article, contact Lewis Robinson at LRobinson@capsouthpartners.com

To learn more about CapSouth and the services we provide, visit our website at capsouthwm.com/what-we-do/ or click here to schedule a Discovery Call.

Investment advisory services offered through CapSouth Partners, Inc., dba CapSouth Wealth Management, an independent Registered Investment Advisor. This material has been prepared for planning purposes only and is not intended as specific tax or legal advice. CapSouth Partners does not provide tax or legal advice. Please consult your tax or legal advisor prior to making decisions which may have tax or legal consequences. Information provided by sources deemed to be reliable.  CapSouth does not guarantee the accuracy or completeness of the information.