By Dean Johns, CPA, CFP®
Executive Vice President, Director – Financial Planning
As we near the Q4 tax estimate deadline on January 15th, I thought it would be worthwhile to quickly review how the rules work for estimated tax payments. We want to make sure you have enough paid in by January 15th to avoid any unnecessary penalties.
For those that are self-employed or may have substantial income outside of a W-2 (rental income or investment income for example), estimated tax payments are a requirement to avoid underpayment of tax penalties. Now, while it is called a “penalty,” it is simply an interest charge. The rates are adjusted quarterly based on the federal short-term rate plus 3%. Currently, the applicable rate is 3%.
While we typically call these “quarterly” estimated tax payments, they are not quarterly as they are due April 15, June 15, September 15 and January 15. For 2020, the first two payments were delayed until July 15th due to COVID.
Most taxpayers typically pay “safe harbor” estimated tax payments to avoid any underpayment penalties. However, safe harbor estimates may not necessarily be the most efficient cash flow technique. If you had any significant one-time gains or income items in that prior tax year, you may want to consider whether a different approach to paying your estimated tax payments makes sense.
Underpayment penalties apply if you don’t pay the lesser of 90% of current year tax (including any self-employment, additional Medicare, or Net Investment Income taxes) or 100% of your prior year tax liability. For those making over $150,000 a year, the 100% prior year tax liability threshold is increased to 110%. These are the federal rules. Most states follow these rules, but some do not require 110% and may simply require 100% for all taxpayers. Please check with your tax advisor as to your state’s rules.
Paying 90% of current year tax may be a much better approach if you had unusually high income in the prior year or your income in the current year has decreased substantially. Either way, wouldn’t you rather have the cash in your bank or money market account earning interest than in the IRS’ account?
Keep in mind that if you are paying safe harbor estimates and you have withholding, you should check your YTD withholding to make sure it is as much as you had in the prior tax year. When tax preparers calculate the safe harbor estimates for the subsequent year, they typically assume the same level of withholding as the prior year. If your withholding decreases, those safe harbor estimates will fall short and you may have some underpayment penalties.
Additionally, if you make most of your other income late in the year, you could consider the “Annualized Income Installment Method” if that generates a better result than assuming you earned the income pro-rata throughout the year. For those that are retired, this method could also apply if you take IRA/401k distributions sporadically and perhaps later in the year for special one-time items (vacations, etc.).
This annualized method may allow you to pay less estimated taxes earlier in the year, when you have not made as much income, and more later in the year, when most of your income is earned. Obviously, this is simply a cash flow play as every taxpayer must pay in the lesser of 90% of current year tax or 100% of prior year tax (110% for those making over $150,000) by January 15th following the tax year to avoid any underpayment penalties.
One other cash flow strategy to consider is that withholding is considered pro-rata regardless of when that withholding actually occurs. For business owners able to pay themselves a bonus in December, they could use that to withhold the required amounts. Same concept applies to those doing substantial IRA distributions. Instead of doing tax withholding each month, you could wait and do it all in December through an additional IRA distribution. These strategies allow you to keep your money invested for as long as possible until taxes are ultimately due.
As part of our expanding tax planning services, we are happy to help you analyze the best approach in 2021 to manage your cash flow while avoiding any underpayment penalties. If you have questions about what you may still owe for 2020 by January 15th, please contact us immediately as the deadline is fast approaching.