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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5741  
Subject: Estimated Taxes Date: 8/5/1997 1:10 PM
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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 Bill
Shakespeare.)

Recent questions have underscored the potential problem of the payment of
estimated taxes. I assume that many other Fools are sitting on realized stock
gains for the year and might also be interested in this question. So lets
take an in-depth look into estimated taxes.

Uncle Sam is looking for at least 90% of your current year taxes in the form
of withholding or estimated tax payments. Remember that the tax system is
that of "pay as you go" (and it seems like the farther you go, the more you
pay). If you are a normal W-2 employee, and compute your withholding
allowances correctly, you will most likely never have to deal with the issue
of estimated taxes. But, if you are a self employed individual, or otherwise
generate taxable income without associated withholding, or if your normal W-2
income "spikes" due to the sale of stocks, property, etc., you need to become
acquainted with the concept of estimated taxes. Lets open up the floor for
questions.

Q: Do I have to pay estimated taxes?

A: Nope

Q: 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 with
the 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, the
form compares what should have been paid (on a quarterly basis) to what was
actually 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 than
happy 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 quarterly
underpayment. But on a $2,000 underpayment which occurred evenly over the
course of the year, the 1996 penalty would have amounted to $140, when the
penalty rates were around 9%. Now don't grab your calculator and figure that
the interest rate is really only 7% ($140 divided by $2,000). The key
words are "evenly over the course of the year." If the underpayment occurred
entirely in January, the penalty would be much higher.

Likewise, if the underpayment occurred entirely in December, the penalty
would be much lower. The only way to correctly estimate your potential
underpayment penalty is to grab Form 2210, sharpen the pencil, heat up the
coffee, and start crunchin' numbers (or run it through your TurboTax
program).

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 the
difference?

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. This
is 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 the
year, 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, you
can't avoid the penalty for those installments by overpaying the final
installment. Remember that each quarter is treated independently. But the
sooner you make the installment, the lower the ultimate penalty will be.

BUT CONSIDER THIS: Withholding from wages (W-2) is treated as paid equally
over all installments. If you have a situation such as the one noted above,
have your employer take out mucho, mucho federal withholding (or at least
enough to cover the previous underpayment) late in the year. This back-loaded
withholding can be used to retroactively abate the penalty. For those of you
with W-2 income, this technique is very valuable.

Q: If I make a large estimated tax payment for the first quarter and then
suffer big losses for the remainder of the year, is it possible to get that
estimated tax payment back?

A: No way, Jose. Once you make the payment, it belongs to Uncle Sam until you
file your tax return. That could be almost a year. If your business or
financial situation is shaky, you might want to consider not making the
estimated tax payment simply to keep your cash flow at a reasonable level.

Q: You mention "quarters." Are the quarters for estimated tax purposes the
same as normal quarters?

A: The more you deal with the tax code, the more you realize that "normal" is
the exception rather than the rule. In this case, the computation quarters
and payment dates do differ and are as follows:

1st quarter is from Jan. 1 to March 31, payment due date is April 15th
2nd quarter is from April 1 to May 31, payment due date is June 15th
3rd quarter is from June 1 to August 31, payment due date is September 15th
4th quarter is from Sept. 1 to Dec. 31, payment due date is Jan.15th of the
following year.

LOOPHOLE ALERT... LOOPHOLE ALERT... LOOPHOLE ALERT...

For those of you who were beginning to doze off, I just thought I would get
your attention. If this is the first year that your income has spiked or
otherwise increased substantially, you still might not have to pay estimated
taxes and might be able to pay the entire balance due on April 15th, without
penalty by using the so-called "exception #1." This exception allows that no
estimated tax penalty will be assessed if your 1996 tax payments are equal to
100% of your 1995 tax liability. But exception #1 is not available to
taxpayers with adjusted gross income (AGI) shown on the previous year return
exceeding $150,000 ($75,000 for married filing separately). For those of you
with AGI greater than $150,000, your penalty free zone amounts to 110% of the
prior years tax. Got that? OK, lets look at an example. Pull out your 1995
Form 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 estimated
tax payments made in a timely fashion MUST be greater than 110% of line 51 of
your 1996 Form 1040 (total tax) in order to avoid any underpayment penalties
for 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 estimated
tax payments made in a timely fashion MUST be greater than 100% of line 51 of
your 1996 Form 1040 (total tax) in order to avoid any underpayment penalties
for 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 any
increases in 1997 income, and pay any balance due with the tax return on
April 15th without penalty.

Okay, that's enough for today. We could spend another two or three pages on
the "Annualized Income Method" relative to estimated taxes, but let's leave
that for another time. For those of you still around that want to know more
about the impact of estimated taxes on your individual tax return, you can
call IRS at (800) TAX FORM (800-829-3676) and request Publication 505
entitled "Tax Withholding and Estimated Tax." Or you can visit the IRS web
site at http://www.irs.ustreas.gov"
and download Publication 505 yourself. Enjoy.
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