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I'm hoping the collective knowledge on this board can help me sort through my thoughts regarding this tax year.

I've had a few big changes this year- I got married in October, and bought a house in August. Both of these have income tax implications, which I knew would happen, but the severity of this situation caught me off-guard.

My wife and I are both employed, earning ~35,000 and ~44,000 respectively. We have no children, and each put 15% pre-tax into tax-deferred retirement accounts- a 401(k), 403(b) and a NC State Employee employer-mandated pension. Neither of us have an IRA, yet.

While I've been withholding at the single rate and 0 allowances, somehow my wife has been withholding at the single rate with 3 (3!!!) allowances. I'm blaming it on her terrible HR department.

Since we bought the house so late in the year, we won't have paid enough interest ($2400) to benefit from itemizing.

After running our numbers through the IRS withholding calculator (http://www.irs.gov/individuals/article/0,,id=96196,00.html), it says that our estimated tax is $7000, but we're only on track to withhold $5300. That will leave us with $1700 due with the tax return in April! The calculator then goes on to suggest setting our allowances to 0 and withholding an additional $466 from my biweekly paycheck and $728 from her one remaining monthly paycheck.

This is not the way to go into Christmas season with a merry outlook.

So I'm pondering a few things:
I know there is a penalty for underwithholding. Is our underwitholding of $1700 going to trigger that penalty?

We have a small (~5000) savings that we were anticipating growing into an e-fund of 15,000 over the next year. Should we, instead, use that savings to fund an IRA with the goal of further reducing our tax while boosting retirement savings?

Perhaps we should crank up our withholding for the next month and live off our savings (withholding an additional $1700 over the next month is going to kill our budget).

Obviously we need to change our allowances and withholdings on Jan 1 for the 2006 tax year.

I also have a small (~4000 at 8%) credit card debt from our honeymoon and some reimbursed business expenses that I was planning to pay off between now and february.

Did I miss any options? Anyone have suggestions? Thanks in advance for being such a great community.
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>> So I'm pondering a few things:
I know there is a penalty for underwithholding. Is our underwitholding of $1700 going to trigger that penalty?
<<

Per the "safe harbor" provisions in Publication 505, if you pay at least 90% of the tax you owe this year, OR 100% of the combined tax burdens for your two (presumably single) returns in 2004, there is no penalty. You're on track to withhold $5,300, you say -- how much did the two of you pay in 2004 (combined)? If less than $5300, there would be no penalty.

Also per Pub 505, there is no penalty if the tax due (amount you owe minus the amount you had withheld) is less than $1000. So if you can crank up the withholding such that your underwithholding is under $1000, there is no penalty and you can pay the difference by April 17, 2006 (since April 15 is a Saturday).

#29
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With underwithholding of $1700, your penalty will be about $50. Is this worth losing sleep over? Since the penalty is 6%/yr, lots of my clients rather pay the penalty and use the money for something else that returns a higher rate.
ED
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I agree with what's been said, but would add a couple of other points:

You mentioned,"We have a small (~5000) savings that we were anticipating growing into an e-fund of 15,000 over the next year. Should we, instead, use that savings to fund an IRA with the goal of further reducing our tax while boosting retirement savings?"

Be aware you won't get an IRA DEDUCTION, or a very limited one, at your income level, as each of you is covered by a qualified plan.
For 2005, the deduction is phased out between $70,000 and $80,000
For 2006, the deduction is phased out between $75,000 and $85,000

You can, however, make a regular nondeductible IRA contribution, or a Roth IRA contribution. I'd recommend the Roth; there's no real advantage to a nondeductible traditional IRA, if the Roth is available as an option.

Also,"Obviously we need to change our allowances and withholdings on Jan 1 for the 2006 tax year."

And remember you will have a full year's worth of mortgage interest and property taxes, when you figure your deductions. (Depending how the property tax system in your area works.)

Bill

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Since we bought the house so late in the year, we won't have paid enough interest ($2400) to benefit from itemizing.

Since you won't get to itemize this year, you might want to look at what you can push into 2006 to maximize your itemizations next year. For example, don't pay your January mortgage payment early if you don't have to so that that month's interest will be deductible next year. Also consider when your property tax payments fall since they are deductible as well.

And I see from your profile that you are a fellow Wolfpacker. Go pack!

sjfans
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Obviously we need to change our allowances and withholdings on Jan 1 for the 2006 tax year.


Correct, next year you should both probably be at 3 deductions. One for you, one for her and one for the house (tax professionals are going to shoot me down as being too simplistic).
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Correct, next year you should both probably be at 3 deductions. One for you, one for her and one for the house (tax professionals are going to shoot me down as being too simplistic).

Yep. Too simplistic. And you miscounted, to boot. If they both claim 3 withholding allowances, that is a total of 6 allowances. And that might result in less withholding than they expect.

--Peter
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While I've been withholding at the single rate and 0 allowances, somehow my wife has been withholding at the single rate with 3 (3!!!) allowances. I'm blaming it on her terrible HR department.

Don't worry about blame. It is a mistake and you need to correct your withholding. Many non-home owners over estimate the value of home ownership deduction.

Have you checked your state withholding? My state has a reputation for underwithholding.

Do you have other deductions for 2005 that might make itemizing of value? The common deductions are real estate taxes, state taxes or sales tax, and chartible deductions. Also if you prepaid interest (points) you have the option of prorating them for the life of the loan or deducting all of them the first year.

If you increase your withholding for the remainder of the year by $700, it will eliminate underwithholding penalty. A different safe harbor is that you have withheld as much as your combined tax liability for 2004. The penalty isn't much and as other have suggested you can just file your return and let the IRS bill you for the small amount of penalty (interest) due.

Even if you do not pay the full balance on April 15th, it is necessary to file by April 15th.

Debra
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And remember you will have a full year's worth of mortgage interest and property taxes, when you figure your deductions. (Depending how the property tax system in your area works.)


How does that work? I can understand the taxes, but it seems that I got a notice that told me exactly how much interest I paid and that seemed to be all I could deduct.

Maybe, since I closed Jan 30th, maybe I didn't notice it, but it doesn't seem like I got to deduct as if I had paid interest in Jan.
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Thanks for all the great responses! Some were duplicate and I'll try to answer as many questions as I can.

how much did the two of you pay in 2004 (combined)? If less than $5300, there would be no penalty.

Unfortunately, we paid $6354 last year. Some of it was due to myself working more than one job, and some of it was due to a bonus I got last year. My wife had to pay almost $500 last year and didn't change her withholdings this year.

if you can crank up the withholding such that your underwithholding is under $1000, there is no penalty and you can pay the difference by April 17, 2006

Can I pay the amount necesary to get my underwithholding down to $1000 in one lump sum by december 31, kinda like the quarterly payments done by the self-employed? I'd like to avoid changing my withholdings twice in 2 months if possible.

With underwithholding of $1700, your penalty will be about $50. Is this worth losing sleep over? Since the penalty is 6%/yr...

Well, a penny saved is a penny earned. I get 1700 * .06 = $102. Am I missing something?

Be aware you won't get an IRA DEDUCTION, or a very limited one, at your income level, as each of you is covered by a qualified plan.

D'oh! Goodbye IRA, I never even knew ya. I was debating between a traditional and a Roth, but I guess that issue is solved. On a related tangent, if I had contributed $4000 early in the year as a single guy and then got married at the end of the year, must I pay a penalty for contributing to an IRA that I'm not qualified for?

And remember you will have a full year's worth of mortgage interest and property taxes, when you figure your deductions. (Depending how the property tax system in your area works.)

Gotcha. That is the plan- no surprises for this forester next year.

Since you won't get to itemize this year, you might want to look at what you can push into 2006 to maximize your itemizations next year.

I'm definitely plannning to bunch our deductions.

And I see from your profile that you are a fellow Wolfpacker. Go pack!

Awesome! Yep, classes of 01 and 03. Go Pack!

Have you checked your state withholding? My state has a reputation for underwithholding

Our state withholding is generally close enough to suit me, but we'll check it just to be sure. Thankfully the 3 allowances my wife took were only on the fed w-4.

Do you have other deductions for 2005 that might make itemizing of value? The common deductions are real estate taxes, state taxes or sales tax, and chartible deductions. Also if you prepaid interest (points) you have the option of prorating them for the life of the loan or deducting all of them the first year.

All the deductions I could come up with amounted to around 7500, and our standard deduction is 10000 for married filing jointly.

Thanks for all the help so far!
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(My prior note:)And remember you will have a full year's worth of mortgage interest and property taxes, when you figure your deductions. (Depending how the property tax system in your area works.)
__________________________________
DBAVelvet74:How does that work? I can understand the taxes, but it seems that I got a notice that told me exactly how much interest I paid and that seemed to be all I could deduct.

Maybe, since I closed Jan 30th, maybe I didn't notice it, but it doesn't seem like I got to deduct as if I had paid interest in Jan.

__________________________________
That's sort of what I was getting at. The original poster bought his home in August; wasn't even sure he could itemize this year. I was referring to estimates to use in his 2006 withholding calculations.

Bill




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2006 withholding calculations.

I can't seem to find a 2006 w-4 worksheet on the IRS site. Are there any important numbers that will change for next year? Should I just wait until december to fill out a new w-4? I suppose the IRS can't act on a new form until this tax package in congress passes.
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ForestRangr writes (in part):

On a related tangent, if I had contributed $4000 early in the year as a single guy and then got married at the end of the year, must I pay a penalty for contributing to an IRA that I'm not qualified for?

I reply:

No, because you will still be eligible. Anyone with earned income is eligible to contribute to a traditional IRA. The question is whether those contributions would be deductible. If they're not, and if you're eligible for a Roth IRA, then the choice is a no-brainer -- each device has the same present tax benefit (none), but the Roth has superior tax benefits down the line (no taxes vs. some taxes).

If you contribute early in the year to a Roth IRA and then discover that you weren't eligible to do so, there are solutions, at least one of which (recharacterizing the contribution) can be implemented the following year. --Bob
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Can I pay the amount necesary to get my underwithholding down to $1000 in one lump sum by december 31, kinda like the quarterly payments done by the self-employed? I'd like to avoid changing my withholdings twice in 2 months if possible.

You can do it, but only by having the additional amount withheld. For estimated tax penalty purposes, withholding is applied equally throughout the year, but estimated tax payments are credited as of the date paid.

With underwithholding of $1700, your penalty will be about $50. Is this worth losing sleep over? Since the penalty is 6%/yr...

Well, a penny saved is a penny earned. I get 1700 * .06 = $102. Am I missing something?


The penalty applies only to the period of underpayment, spread equally through the year. For 2003, the last year for which I have the number handy, the annualized rate was approximately 2.9%. So, no, it would be much less than 6% of the total, although I can't give you the exact amount.

Goodbye IRA, I never even knew ya. I was debating between a traditional and a Roth, but I guess that issue is solved. On a related tangent, if I had contributed $4000 early in the year as a single guy and then got married at the end of the year, must I pay a penalty for contributing to an IRA that I'm not qualified for?

Did you make a 2005 IRA contribution or not? If you did, we'll go into the details of your options here. If you're just curious, read about recharacterizations and nondeductible traditional IRA contributions in the FAQ over there --------------------->.

Moving on to your next post, the 2006 figures have been released, but I don't know if the 2006 W-4 is out yet or not. You can find the figures in Rev. Proc 2005-70, which you can get from the IRS site. For W-4 purposes, use the 2005 version and make the following changes:

On the Deductions and Adjustments Worksheet:

Line 2 is $10,300

Line 8: the divisor is $3,300

For the two-earner worksheet:

I don't know enough about the innards of the tables to tell you how to adjust them, but if you use the 2005 version you won't be underwithheld. You can always revisit it when the 2006 W-4 is available.

Phil
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With underwithholding of $1700, your penalty will be about $50. Is this worth losing sleep over? Since the penalty is 6%/yr...

Well, a penny saved is a penny earned. I get 1700 * .06 = $102. Am I missing something?


yes. the per year part. It will only be $102 if you don't pay it for a whole year.
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Can I pay the amount necesary to get my underwithholding down to $1000 in one lump sum by december 31, kinda like the quarterly payments done by the self-employed? I'd like to avoid changing my withholdings twice in 2 months if possible.

Estimated tax payments are treated differently than withholding. Withholding is assumed to be equal across the year regardless of the actual timing of the withholding. Estimated tax payments are applied when received. You can eliminate most of the penalty by making an estimated tax payment and not changing withholding.



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Well, a penny saved is a penny earned. I get 1700 * .06 = $102. Am I missing something?

The underwithholding penalty only applies to the amount underwithheld which is $700 and not the full $1,700. Also since the interest is based on the daily amount underwithheld, the full amount is not underwithheld for the full year.

Debra
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The penalty for underwithholding is .03184 times the underwithheld amount if you make up the difference on April 15. At 7% simple interest, this amount varies if you pay before April 15.
Although there is no penalty if you underwithheld less than $1,000, that number is not applicable when figuring the penalty, which is based on either last year's tax or 90% of this year's tax. In other words, either rely on the $1,000 OR figure the penalty on the last year or 90% of this year's tax safe harbors.
If you can't increase your withholding by $700 paying an installment of that amount won't get rid of the underwithholding in early quarters and per above may not help you more than eliminating the simple interest (at 7%) on the $700. ed
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If you can't increase your withholding by $700 paying an installment of that amount won't get rid of the underwithholding in early quarters and per above may not help you more than eliminating the simple interest (at 7%) on the $700. ed

Given the amount of taxes paid last year and what will be owed this year, the best option is to rely on the $1,000 safe harbor.

The total estimated amount of underwithholding is $1,700 which is approximately $425 a quarter. Since there is no penalty until the amount exceeds $1,000, there shouldn't be any underwithholding penalty for the for the first two quarters. If an estimated payment of $700 is made, it would stop any additional underwithholding penalty.

The underwithholding did not exceed $1,000 until the end of third quarter. Wouldn't making an estimated payment of $700 limit the underwitholding penalty to the amount over $1000 (approx $375) for one quarter (fourth quarter)?

Debra
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Since there is no penalty until the amount exceeds $1,000, there shouldn't be any underwithholding penalty for the for the first two quarters.

No.

When, at the end of the year, it is determined that an underpayment penalty applies, you go back to all four quarters and apply the penalty. In this case, the underpayment is about $425 a quarter and the penalty will apply to each quarter on the full amount.

--Peter
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No, Debra. You can't use the $1,000 if you paid any installments, only withholding. Also, Making a $700 payment now just stops the interest from running further, and it isn't the right amount for the 2 safe harbors.

If you pay an installment in a late quarter the IRS wants to know why you didn't make it earlier, so you have to complete the Schedule AI of form 2210to prove your income actually increased late in the year (and not earlier). Get form 2210 and you'll see how they figure the underpayment penalty, and that the $1,000 is a stand-alone situation to avoid a penalty, but it must be met with withholding only and does not function the same way as the 90% of current year's tax. ed
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You can do it, but only by having the additional amount withheld. For estimated tax penalty purposes, withholding is applied equally throughout the year, but estimated tax payments are credited as of the date paid.

I understand now, thanks to this and other responses below. The IRS considers the tax due when the income is received, so an estimated tax payment is only appropriate if I recieved extra income without the proper withholding in that quarter. I'll just have to increase my withholding for my last few checks. Thanks!

The penalty applies only to the period of underpayment, spread equally through the year. For 2003, the last year for which I have the number handy, the annualized rate was approximately 2.9%. So, no, it would be much less than 6% of the total, although I can't give you the exact amount.

Ok, gotcha. Now it makes a little more sense.

Did you make a 2005 IRA contribution or not? If you did, we'll go into the details of your options here. If you're just curious, read about recharacterizations and nondeductible traditional IRA contributions in the FAQ over there --------------------->.

No, the question was just out of curiosity. I had been thinking about making a traditional IRA contribution, but it sounds like a Roth is the right way to go this year. Thanks for the link.

Moving on to your next post, the 2006 figures have been released, but I don't know if the 2006 W-4 is out yet or not. You can find the figures in Rev. Proc 2005-70, which you can get from the IRS site. For W-4 purposes, use the 2005 version and make the following changes...

Thanks, sir! I don't plan to be in this situation next year.

Thank you to all the participants on this thread- you all cleared the cobwebs from my thinking.
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