We’re already halfway through 2024, and one of the best proactive tax planning strategies is doing a mid-year check in on your projected income and tax liability. Generally, I see the most issues around tax planning when income in the current year changes substantially from the prior year.
According to the Wall Street Journal, “The average estimated-tax penalty in fiscal-year 2023 climbed to about $500 from about $150 in 2022, according to Internal Revenue Service data. Meanwhile the number of affected tax filers rose to 14 million from 12 million. Overall, the agency assessed $7 billion in estimated-tax penalties in 2023, nearly four times the $1.8 billion it assessed in 2022.
I was reading the aforementioned WSJ article a few weeks ago and thought to myself “I don’t need IRS data to confirm the rise in these penalties, I’ve seen it first hand with numerous clients and prospective clients just this year.” Fortunately for our clients, we were able to catch the tax discrepancies and make adjustments in time. Some of the prospective clients weren’t so lucky – many times getting a big tax bill and a penalty from the IRS, just to rub salt in the wound.
Most Americans are aware they must pay federal income tax. Most Americans also have their federal income tax withheld from their paycheck by their employer. But what if you have income from other sources outside of your paycheck? Or, what if your employer isn’t withholding enough from your paycheck? You could be assessed penalties for underpayment of income taxes. So let’s dig into who might need to make estimated tax payments and how to avoid getting IRS imposed underpayment penalties.
With the rise in the gig economy and stock market, more people are sourcing income from outside their primary job, and may need to make estimated payments. Whether it is a full time job being self employed, part-time job as an uber driver, selling artwork on Etsy, or investing your extra savings in the stock market or rental properties, you’ll likely need to make estimated tax payments to avoid not only owing a hefty tax bill when you file taxes, but also earning yourself a penalty.
Who is most likely to get hit with underpayment penalties?
- Self-employed individuals
- Investors (Capital Gains, Dividends, Interest, & Real Estate)
- Employees that receive a substantial part of their compensation from commissions
- Employees who receives stock options
Estimated tax payments are how individuals with sources of income other than a paycheck pay income tax during the year, before they file their tax returns.The first two individuals listed above don’t have tax withheld from those sources of income and remitted to the IRS. It is up to that individual to remit income taxes to the IRS via estimated tax payments. Estimated tax payments are made quarterly on April 15th, June 15th, September 15th, and January 15th.
The second two groups of people have W-2 withholding, but the large fluctuations in income from commissions and/or stock options might drastically affect their tax bracket and how much they owe year-over-year. Based on the default withholding rules their employer utilizes, enough tax may not be withheld from those large infrequent payments. These individuals may need to have additional withholding collected by their employer, or make estimated payments on their own.
Safe Harbor – IRS rules to avoid underpayment penalties
I’m sure many of you have owed a small amount in taxes before if your employer marginally underwithheld from your paycheck or you had a small amount of investment income. Larger underpayments can trigger penalties if you do not satisfy one of the IRS rules surrounding minimum tax payments throughout the year.
There are several rules to qualify for “safe harbor” and not be penalized for under payment of taxes.
- Owe less than $1,000 of tax when you file your return; or
- For those that make $150,000 or less a year (based on prior year AGI), you must pay at least 90% of current year OR 100% or prior year tax via estimated payments; or
- For those that make more than $150,000 a year (based on prior year AGI), you must pay at least 100% of current year OR 110% or prior year tax via estimated payments.
If you have satisfied one of the aforementioned safe harbor tests, you will not owe underpayment penalties. It’s important to remember, you may still owe income tax when you file your return, but you will not be penalized for under payment. If you have not satisfied one of those tests, you will likely owe a penalty.
Where do I see under payments happen frequently?
Business Owner
- Especially businesses with fluctuating income from year to year. Realtors are a prime example. They often have wildly fluctuating income throughout the year, and from year-to-year. Realtors who do not meet minimum estimated tax payments throughout the year can be hit on their underpayment when they file their returns.
Investors (especially with large capital gains)
- Say an Individual makes $200,000 a year but that income can fluctuate based on bonuses, commissions and/or equity options. In March they sold a large appreciated stock position in their taxable brokerage account for the down payment on their first home. The realized capital gain on the stock disposition triggers a $10,000 capital gains tax. Their employer underwithheld on their W-2 and the individual doesn’t pay any estimated tax payments throughout the year. They will likely have a penalty.
- As a side note. I’ve seen many investors who aren’t even aware of capital gains tax. So this can be a case of the double whammy. They file their return, their employer underwithheld and they realize they owe an additional $10,000 from selling the stock position and a penalty on top of that.
Large Income Fluctuation and No W-4 update
- Someone receives a large internal promotion and the employer continues using their old W-4 information. I saw this twice last year. The employer was calculating withholding off 3 year old salary data. In the second year of their promotion they missed a bonus goal and received a reduced bonus so their income went down from the prior year. However, the employer still underwithheld their income tax by almost $15,000. They were on track to get a penalty, but were able to make some withholding changes before year end to prevent that from happening.
Commission Structure
- Similar to the aforementioned. In this situation a company uses a flat withholding rate company wide on commissions. With large fluctuations from year to year, in the high commission years, the company is likely underwithholding from the paycheck. I will discuss some remedies for this below.
Stock Options
- Corporations that issue stock options or RSU’s (Restricted Stock Units) to management level employees. When these vest, they are counted as income. We have seen numerous cases where companies withhold taxes at a much lower rate than should be because the stock options have pushed the employee up into a higher tax bracket than their base salary. Sometimes this may even be a tax bracket 2-3 brackets higher than their usual bracket. The individual may have these options vesting over a number of years and can get hit with underpayment penalties if they are not paying attention to their pay stubs throughout the year.
I paid estimated taxes and still got a penalty?
Without getting into minutia, the IRS looks at income tax paid through withholding much different than by estimated payments. Money withheld from your paycheck is seen as being done evenly throughout the year, whereas estimated payments are seen in the IRS’s eyes as only occurring in the quarter the payment is made.
This means that even if you’ve made estimated payments to meet the safe harbor rules, you could still technically have an estimated payment penalty. I’ll provide a few scenarios below to elaborate on this.
Example 1
- Your company underwithheld from your paycheck. In the fourth quarter you realize and have them withhold extra from your bonus paycheck to meet one of the safe harbor requirements. You will not have a penalty.
Example 2
- You sold a stock position in February and had a $50,000 capital gain and $10,000 tax bill. In the fourth quarter you realized you had not paid any tax on it and made an estimated payment in December. You may have a penalty on this because the transaction was in the 1st quarter and estimated payment was made in the 4th quarter.
Example 3
- You sold a stock position in February and had a $50,000 capital gain and $10,000 tax bill. In the fourth quarter you realized you had not paid any tax on it and had your employer withhold extra from your paychecks throughout the rest of the year to make up for it. You will likely not have a penalty because the tax came from withholding.
The scenarios are all similar but it is where the income tax was paid from that changes the outcome. Because estimated taxes are assessed on a quarter by quarter basis, the second scenario was late paying taxes, and thus potentially incurred a penalty.
Rising rates bite again
Rising interest rates have been affecting numerous sectors of the economy. Whether it is mortgage rates, car loans, student loans, or credit cards, interest rates have pretty much risen across the board. Another place higher rates are hitting is the interest rate charged on underpayment. According to the WSJ, “In 2021, the year that prompted most of the 2022 assessments, the IRS’s rate on underpayments was a rock-bottom 3%. The penalty is based on the short-term Treasury rate plus three points, and it climbed to 6% as rates rose in 2022. That pushed up charges on underpayments assessed the next year. In 2023 the rate rose to 8% for the fourth quarter. It’s still there–so underpayment penalties will continue to sting taxpayers who owe them.
And while penalties are typically relatively small compared to the tax bill from underpayment, nobody wants to end up with a large tax bill and an inflated penalty on top.
Mitigating underpayment Penalties
The rules surrounding estimated payments and penalties can get more complex when you bring into play scenarios with withdrawals from IRAs, pensions, Roth conversions, and other sources of income. For starters, it is important for individuals to track their income and withholding throughout the year – both from their paychecks and other sources of income such as investments and part time jobs. Tracking and projecting income and taxes throughout the year can reveal your marginal and effective tax rates and help you stay on top of tax payments so you don’t get hit with both a surprise tax bill and a potential penalty.
I’ve yet to talk to one person who enjoys paying more taxes than they need to. While you might not always be happy with your tax bill at the end of the year, doing some proactive planning throughout the year can ensure there are no surprises when it comes time to pay. It’s also important to remember that good tax planning is about reducing your tax bill over the lifetime of your financial plan and not in any given year in isolation.
As income and financial complexity increase, it is wise to consult with an accountant or Certified Financial Planner™ on income and tax planning. Many times the fee these professionals charge can be more than offset by the value of mitigating tax liabilities and preventing tax penalties.
