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You have two problems and this discussion is limited to only the amount of penalty due to underwithholding (problem #2).

First: You owe 2002 taxes which start accruing interest and penalty starting on 4/16/03. To stop the interest and penalties pay the shortage ASAP. Resetting your withholding for 2003 is an obvious necessity but can't correct these problems. I hope you can find more to deduct to reduce the taxes owed.

Second: You owe interst (penalty) for underpaying your taxes (not enough withholding in 2002). However, if you owe less than $1,000, there is no penalty. If you withheld at least as much as 2001 total taxes, no penalty, or if you withheld at least 90% of 2003 taxes, no penalty. I think CA penalties are similar.

The penalty is 5% simple interest on how much you missed these marks (except the $1,000). The first page of IRS form 2210 will show you the amount of penalty the IRS will calculate for you in the "Short Method".

You can reduce the penalty if:
1. you made the payments leading to your deductions ( or enough to get the full deduction) in the early part of the year (such as a capital loss carryover or retirement savings deposit), or
2. Your income was higher in the later part of the year (such as from mutual fund distributions or a bonus), or
3. You had more withholding in the early part of the year.
To take advantage of #1 oro #2 you need to complete form 2210 Schedule AI. For #3 you need to apply withholding in the quarters withheld instead of averaged over the year, an option on form 2210. If #2 was due to a bonus, #3 probably isn't going to be to your advantage.
You may be able to use all 3. There is a FREE demonstrator you can download to calculate the first quarter of the 2210 AI for either year, 2002 or 2003 at http://www.edcosoft.com/qitc.html Although the program was designed to compute future installments for self employed or retire taxpayers, it will work for computing the effect of #1, #2 and #3 above for last year. IF the program readout shows a first quarter required installment (or withholding) due of less than the displayed safe harbor amount, using the AI will reduce your penalty. Your tax program will prepare the forms for you or you can register the program to compute the later quarters. You need EXcel 97 or later to rund the program, however, you can download and then copy the unzipped file to a floppy disk and run it on any computer that has Excel97. I hope this helped you. ed
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