Many taxpayers needlessly pay the IRS thousands of dollars each year through the payment of estimated tax penalties. In fact, the IRS estimates that 10 million people paid estimate tax penalties in 2015. Estimated tax penalties are assessed when a taxpayer is obligated to make estimated tax payments, but does not pay enough throughout the year when the estimated payments are due. As a general rule, federal and state income tax is due each time a taxpayer earns income, known as a “pay-as-you-go” system. This means that an employee who receives a paycheck every week must pay tax on those wages every week. For wage income, however, the Internal Revenue Code makes the employer responsible to withhold the tax from the employee’s weekly wages and pay it over to the government on the employee’s behalf.
Similarly, many other income sources often provide options to withhold taxes, such as Social Security income or distributions from a retirement account. A person who takes a large distribution from a taxable retirement account, but does not have income tax withheld, may face estimated tax penalties at the end of the year. Further, other sources of income – self-employment income, investment income, distributions from an S corporation or limited liability company, and independent contractor income – may subject the recipient to estimated tax penalties if steps are not taken to pre-pay the tax. The general rule addressing the self-employed withholding requirements is discussed below, as are several options to plan ahead and avoid estimated tax penalties.
Option 1: Increase your withholding. Those who receive wages or other payments subject to income tax withholding may make adjustments to increase their withholding to cover other sources of income not subject to withholding. Withholding is based on an employee’s Form W-4, Employee’s Withholding Allowance Certificate. An employee will often complete a Form W-4 upon starting a new job, but forget to adjust their withholding when life circumstances change. Life events such as marriage, divorce, working a second job, running a side business or receiving other income can affect the amount of tax that should be withheld. Form W-4 contains instructions and worksheets to assist taxpayers with determining the correct amount of withholding each pay period, including additional amounts selected by the employee on top of the minimum. If, for example, an employee works a full-time job receiving wages and also has frequent investment income, the employee can choose to have his employer withhold an extra $50 or $500 per pay period. Assuming the additional withholding amount is sufficient to cover the investment income, the employee should not be subject to estimated tax penalties.
Option 2: Pay estimated taxes at least quarterly. Many business owners and independent contractors have no choice but to make estimated tax payments as they earn income. The general rule is that individuals must pay estimated taxes (along with other withholding) equal to 90% of the tax that will be due on the current year’s return, or 100% of the tax shown on the last year’s tax return. Estimated tax payments are made by completing, on a quarterly basis, Form 1040-ES, Estimated Tax Voucher, and mailing the voucher along with a check payable to the “U.S. Treasury” for the current taxes due. Payments may also be made online now at IRS.gov/payments. Although estimated tax payments are typically made on a quarterly basis, payments can be made more often if desired, such as for cash flow purposes. Form 1040-ES contains detailed instructions and worksheets to help taxpayers calculate the correct amount of tax to be pre-paid.
Option 3: Take advantage of extra withholding opportunities. Often, when a taxpayer opens a new investment account, the financial institution will ask whether the taxpayer would like taxes withheld from investment income or distributions. Similarly, a taxpayer who receives taxable retirement distributions will often be asked whether he or she would like taxes withheld from the distribution. Many investors ignore this question or intentionally choose not to withhold taxes from their investment or retirement income. However, taking advantage of federal and state income tax withholding capabilities from investment or retirement accounts can reduce headaches and penalties later. Consider contacting your financial institution to ask whether income tax withholding is available for taxable income generated from your account(s).
A practical perspective. Paying estimated taxes or increasing withholding will not only prevent penalties from being assessed, but doing so can also potentially save much more. As tax attorneys, GCK helps numerous taxpayers with federal income tax liabilities that have become overwhelming. The problem often originates when a client skips one estimated tax payment because they think the money is needed elsewhere. The next quarter, the client again needs the money to pay other bills, and since he or she already skipped one payment, a second skipped payment seems insignificant. At the end of the year, the client files his federal income tax return which results in a tax bill far greater than the client’s ability to pay. The IRS then compounds the problem by assessing estimated tax penalties, late payment penalties, and interest, all of which continue to accrue until the tax is paid in full. A taxpayer may then need to seek the advice of a tax professional, which adds to the unexpected costs. Had the client prioritized payment of each quarterly estimated tax payment, he or she would have saved a significant sum by avoiding penalties and interest and attorney’s fees. The mental anxiety associated with tax liabilities can also be avoided by being proactive and determining your income tax obligations.
If you need assistance with an existing federal or state tax debt or tax planning to avoid such a headache, GCK attorneys have a wealth of experience resolving tax-related issues. GCK tailors each client’s resolution to the facts of the case, with a goal to obtain the best possible result given the particular circumstances. Call GCK today to discuss your case and possible solutions.
Sandra Mertens
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