Here is the information on estimated taxes that you will be interested in. After you read it, if you have any follow up questions, let me know.To pay, or not to pay. That is the question. (With apologies to BillShakespeare.)Recent questions have underscored the potential problem of the payment ofestimated taxes. I assume that many other Fools are sitting on realized stockgains for the year and might also be interested in this question. So letstake an in-depth look into estimated taxes.Uncle Sam is looking for at least 90% of your current year taxes in the formof withholding or estimated tax payments. Remember that the tax system isthat of "pay as you go" (and it seems like the farther you go, the more youpay). If you are a normal W-2 employee, and compute your withholdingallowances correctly, you will most likely never have to deal with the issueof estimated taxes. But, if you are a self employed individual, or otherwisegenerate taxable income without associated withholding, or if your normal W-2income "spikes" due to the sale of stocks, property, etc., you need to becomeacquainted with the concept of estimated taxes. Lets open up the floor forquestions.Q: Do I have to pay estimated taxes?A: NopeQ: Well, if I don't pay them and should have, what happens?A: Nothing happens that paying money won't solve (what a great country, eh?).You will be assessed an estimated tax penalty. This penalty can be paid withthe tax balance due on the normal tax return filing date (April 15).Q: How is the penalty computed?A: The penalty will be computed on IRS Form 2210. In very simple terms, theform compares what should have been paid (on a quarterly basis) to what wasactually paid, and computes the deficiency by using an interest rate factor.If you are too lazy to complete the Form 2210, the IRS will be more thanhappy to complete it for you. Q: What is the interest rate used to compute the penalty?A: Currently 9%, compounded daily. Q: How much exactly is the penalty?A: That's impossible to say, since the penalty is computed on the quarterlyunderpayment. But on a $2,000 underpayment which occurred evenly over thecourse of the year, the 1996 penalty would have amounted to $140, when thepenalty rates were around 9%. Now don't grab your calculator and figure thatthe interest rate is really only 7% ($140 divided by $2,000). The keywords are "evenly over the course of the year." If the underpayment occurredentirely in January, the penalty would be much higher. Likewise, if the underpayment occurred entirely in December, the penaltywould be much lower. The only way to correctly estimate your potentialunderpayment penalty is to grab Form 2210, sharpen the pencil, heat up thecoffee, and start crunchin' numbers (or run it through your TurboTaxprogram).Q: OK, then. If I can make more than 9% on my money, would I be better off not paying the estimates, pay the penalty at the end of the year, and pocket thedifference?A: You bet. It happens all the time. But be careful with your computations.Make sure to get a copy of Form 2210 and do the computations yourself. Thisis a tricky game, and if you guess wrong, the lesson could be painful.Q: What happens if the underpayment (i.e. stock sale) happens early in theyear, but I wait until the end of the year to make the estimated tax payment?Do I avoid the penalty?A: Legally, no. If you underpay any of the first three installments, youcan't avoid the penalty for those installments by overpaying the finalinstallment. Remember that each quarter is treated independently. But thesooner you make the installment, the lower the ultimate penalty will be.BUT CONSIDER THIS: Withholding from wages (W-2) is treated as paid equallyover all installments. If you have a situation such as the one noted above,have your employer take out mucho, mucho federal withholding (or at leastenough to cover the previous underpayment) late in the year. This back-loadedwithholding can be used to retroactively abate the penalty. For those of youwith W-2 income, this technique is very valuable.Q: If I make a large estimated tax payment for the first quarter and thensuffer big losses for the remainder of the year, is it possible to get thatestimated tax payment back?A: No way, Jose. Once you make the payment, it belongs to Uncle Sam until youfile your tax return. That could be almost a year. If your business orfinancial situation is shaky, you might want to consider not making theestimated tax payment simply to keep your cash flow at a reasonable level. Q: You mention "quarters." Are the quarters for estimated tax purposes thesame as normal quarters?A: The more you deal with the tax code, the more you realize that "normal" isthe exception rather than the rule. In this case, the computation quartersand payment dates do differ and are as follows:1st quarter is from Jan. 1 to March 31, payment due date is April 15th2nd quarter is from April 1 to May 31, payment due date is June 15th3rd quarter is from June 1 to August 31, payment due date is September 15th4th quarter is from Sept. 1 to Dec. 31, payment due date is Jan.15th of thefollowing year. LOOPHOLE ALERT... LOOPHOLE ALERT... LOOPHOLE ALERT... For those of you who were beginning to doze off, I just thought I would getyour attention. If this is the first year that your income has spiked orotherwise increased substantially, you still might not have to pay estimatedtaxes and might be able to pay the entire balance due on April 15th, withoutpenalty by using the so-called "exception #1." This exception allows that noestimated tax penalty will be assessed if your 1996 tax payments are equal to100% of your 1995 tax liability. But exception #1 is not available totaxpayers with adjusted gross income (AGI) shown on the previous year returnexceeding $150,000 ($75,000 for married filing separately). For those of youwith AGI greater than $150,000, your penalty free zone amounts to 110% of theprior years tax. Got that? OK, lets look at an example. Pull out your 1995Form 1040 and follow along:1. Is line 31 of your 1996 Form 1040 (adjusted gross income) greater than$150,000? If so, your combination of 1997 W-2 withholding and/or estimatedtax payments made in a timely fashion MUST be greater than 110% of line 51 ofyour 1996 Form 1040 (total tax) in order to avoid any underpayment penaltiesfor 1997. 2. Is line 31 of your 1996 Form 1040 (adjusted gross income) less than$150,000? If so, your combination of 1997 W-2 withholding and/or estimatedtax payments made in a timely fashion MUST be greater than 100% of line 51 ofyour 1996 Form 1040 (total tax) in order to avoid any underpayment penaltiesfor 1997.So if your 1997 withholding is at least as much as your 1996 total tax(assuming that your AGI is less than $150,000), you can blow off anyincreases in 1997 income, and pay any balance due with the tax return onApril 15th without penalty.Okay, that's enough for today. We could spend another two or three pages onthe "Annualized Income Method" relative to estimated taxes, but let's leavethat for another time. For those of you still around that want to know moreabout the impact of estimated taxes on your individual tax return, you cancall IRS at (800) TAX FORM (800-829-3676) and request Publication 505entitled "Tax Withholding and Estimated Tax." Or you can visit the IRS website at http://www.irs.ustreas.gov"and download Publication 505 yourself. Enjoy.
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