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This article (written by "TMFTaxes") may be on the Fool site somewhere, but I received it in email last year. I think it will answer your questions... but if not you might want to post to the Tax Strategies board (Roy hangs out there).

Estimated Taxes
(and How to Avoid Them)

By Roy Lewis

To pay, or not to pay. That is the question.
(With apologies to Bill Shakespeare)

So, you finished your tax return and... HORRORS... you find that you have a large balance due. Adding insult to injury, your tax prep software (or even your friendly accountant) has also computed an "underpayment penalty" based on your large balance due. What does it all mean? Is there any way to get out of the penalty? Are you now required to make estimated quarterly payments for every future year as long as you live? Let's take a few minutes to discuss how Uncle Sammy expects to be paid his pound of flesh... oops... I mean his fair share. Uncle Sammy 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 "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 self-employed or otherwise generate taxable income without associated withholding, or if your normal W-2 income "spikes" due to the sale of stocks, a large bonus, etc., you need to become acquainted with the concept of estimated taxes, and how to get around 'em. Let's 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 17 for tax year 1999).

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 using an interest rate factor. If you are too lazy to complete 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 on the current Treasury Bill rates, but 2000 will probably see a rate close to 8%, on average.

Q: How much is the penalty exactly?

A: That's impossible to say, since the penalty is computed on the quarterly underpayment. But, on a $2,000 underpayment that occurred evenly over the course of the year, the 1999 penalty amounts to about $100. 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 greater. Likewise, if the underpayment occurred entirely in December, the penalty would be much less. 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 8% on my money, would I be better off not paying the estimates -- paying the penalty at the end of the year and pocketing 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 quite painful.

Q: What happens if the underpayment (e.g., 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 late in the year (ask for a copy of Form W-4 from your employer to do this, or download one from the IRS website). 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. This additional withholding is the cornerstone of the "safe harbor" penalty buster that we'll discuss later.

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

First quarter is from Jan. 1 to March 31, payment due date is April 15 Second quarter is from April 1 to May 31, payment due date is June 15. Third quarter is from June 1 to August 31, payment due date is September 15. Fourth quarter is from Sept. 1 to Dec. 31, payment due date is January 15 of the following year


For those of you who were beginning to doze off, I just thought I'd get your attention. If this is the first year your income has spiked or otherwise increased substantially, you still might not have to pay estimated taxes. You might be able to pay the entire balance due on April 15 without penalty by using the so-called "exception #1" (also known as the "safe harbor" exception).

With this exception, no estimated tax penalty will be assessed if your 1999 tax payments are equal to 100% of your 1998 tax liability. And, contrary to popular belief, the safe harbor is also available to taxpayers with 1998 adjusted gross income (AGI) exceeding $150,000, but in a slightly different form. For those of you with 1998 AGI greater than $150,000, your 1999 penalty-free zone amounts to 105% of your 1998 tax. Got that? No? OK, let's look at an example. Pull out your 1998 Form 1040 and follow along:

1. Is line 33 of your 1998 Form 1040 (AGI) greater than $150,000? If so, your combination of 1999 W-2 withholding and/or estimated tax payments made in a timely fashion MUST be greater than 105% of line 56 of your 1998 Form 1040 (total tax) to avoid any underpayment penalties for 1999.

2. Is line 33 of your 1998 Form 1040 (AGI) less than $150,000? If so, your combination of 1998 W-2 withholding and/or estimated tax payments made in a timely fashion MUST be equal to or greater than 100% of line 56 of your 1998 Form 1040 (total tax) to avoid any underpayment penalties for 1999.

So, if your 1999 withholding is at least as much as your 1998 total tax (assuming that your AGI is less than $150,000), you can blow off any increases in 1999 income, and pay any balance due with the tax return on April 17 without penalty.

Do you now see how "back-loaded" W-2 withholding can help you out substantially? You have the ability to enter the safe harbor by taking enough withholding at year-end to cover 100% (or a greater percentage if your AGI is greater than $150,000) of your prior-year tax liabilities. While you didn't actually pay these withholding taxes until later in the year, Uncle Sammy treats them as being paid evenly over the course of the year. But, be careful: As we noted above, estimated tax payments made late in the year don't have the same penalty-bustin' impact. So, this is a real penalty-saving opportunity just for you W-2 wage earners.

Q: I've heard about recent tax law changes to these estimated tax rules. Is that true?

A: Yup. The new law increased the threshold for the underpayment penalty from $500 to $1,000. This means that no estimated tax penalty will be imposed if your balance due 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 AGIs greater than $150,000? Any changes there?

A: There sure are. Uncle Sammy fiddled with the safe harbor rates. They are:

AGI Greater Than $150,000 Current Tax Year Safe Harbor %
1998 1999 105%
1999 2000 108.6%
2000 2001 110%
2001 2002 112%
2002 2003 110%

So, you will have to stay in close contact with your estimated tax liabilities to sail into the safe harbor in the tax years to come.

OK, that's enough for today. We could spend another two or three hours on the "Annualized Income Method" relative to estimated taxes, but let's leave that for another time. For those of you who want to know more about the impact of estimated taxes on your individual tax return, visit the IRS website and take a look at IRS Publication 505 yourself. Enjoy.

(If you like the way Roy simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

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