Message Font: Serif | Sans-Serif
No. of Recommendations: 0
<<do I file/pay estimated taxes on
the gains before the end of January? If I understand the rules correctly, I could be fined if I >>

Here is the information that you might find useful regarding estimated taxes. Pay special attention to the 100%/110% penalty exception. You may qualify for this "loophole", and may be able to pay any balance due on your 1997 return in April of 1998 without penalty.


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: It varies each quarter, depending upon current Treasury Bill rates, but 1997 will probably see a rate close to 9% on average.

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 about $125. Now don't grab your calculator and figure that the interest rate is really less than 9%. 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.


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 1997 tax payments are equal to 100% of your 1996 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 1996 Form 1040 and follow along:

1. Is line 31 of your 1995 Form 1040 (adjusted gross income) greater than $150,000? If so, your combination of 1996 W-2 withholding and/or estimated tax payments made in a timely fashion MUST be greater than 110% of line 54 of your 1995 Form 1040 (total tax) in order to avoid any underpayment penalties for 1996.

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 51of 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.

Q: I've heard that the new Tax Law (TRA 1997) has made some changes to these estimated tax rules. Is that true?

A: It sure is. First of all, since many provisions of TRA '97 were instituted on a "retroactive" basis, the IRS has said that the estimated tax penalty will NOT be imposed for any installment to the extent that the underpayment was created or increased by the '97 tax act if the period covered by the installment is before January 1, 1998 and the due date of the installment payment is before January 16, 1998. But remember that this relief is ONLY for tax issues directly related to the '97 tax act. If you just screwed up your estimated payments, don't expect this change to bail you out.

Q: Any other changes?

A: Yup. The new law increases the threashold for the underpayment penalty from $500 to $1,000 effective in 1998. This means that no estimated tax penalty will be imposed if the total tax liability for the year, reduced by any withholding or credits is less than $1,000. This provision will provide relief to quite a few taxpayers.

Q: How about changes to "high income" individuals...those with AGI over $150,000 as you covered earlier. Any relief there?

A: There sure is. TRA '97 substitutes the words "the applicable percentage" for "110%" for purposes of determining the preceding years tax safe harbor for individuals with AGI greater than $150,000 for the preceeding tax year. But the new rules don't apply if the preceeding tax year begins in 1997. This is a MAJOR PLUS for many of us. By not requiring payments of the applicable percentage where the preceding tax year begins in 1997, the general rule that requires annual payments of only 100% of the preceding year's tax applies. This being the case, you can base your 1998 estimated taxes on 100% of the tax shown on your 1997 tax return, regardless of your AGI for 1997. So at least potentially, high income taxpayers will have one "free" year in which to use the 100% exclusion, and dodge the estimated tax penalty.

But for tax years beginning after 1998, the applicable percentage (safe harbor) is determined as follows:

...for 1999, the applicable percentage is 105%
...for 2000, the applicable percentage is 105%
...for 2001, the applicable percentage is 105%
...for 2002, the applicable percentage is 112%
...and for 2003 and later, the applicable percentage is 110%

So you will have to stay in close contact with your estimated tax liabilities in order to cover yourself with the safe harbor blanket in the tax years to come.

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
Print the post  


In accordance with IRS Circular 230, you cannot use the contents of any post on The Motley Fool's message boards to avoid tax-related penalties under the Internal Revenue Code or applicable state or local tax law provisions.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.