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You won't necessarily incurr an underpayment penalty. There are a few methods that you can use to avoid the underpayment penalty on an 'up' income year. I'll give you a repost from the Taxes Frequently Asked Questions area that deals with this specific problem.

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: For 1997 the rate will probably be around 9%...but since the year isn't over, this is just a guess.

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 $115. Now don't grab your calculator and figure that the interest rate is really only 5.75% ($115 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.


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 1996 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 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 1996 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 and download Publication 505
yourself. Enjoy.

Hope this helps...
TMF Taxes
Roy Lewis

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