How Do You Pay Your Income Taxes?

Withholding is easy, but estimated tax payments may save you a penalty! Understanding how estimated quarterly tax payments work can help prevent an unexpected tax bill or potential underpayment penalty.

Not everyone can rely on withholding from their paychecks. Business owners, independent contractors, retirees, and even traditional employees with income from other sources may need to make estimated tax payments throughout the year.

Tax Payments – The Basics

The federal income tax system operates under a pay-as-you-go structure. Rather than waiting until your tax return is filed to pay your entire tax liability, the IRS expects taxes to be paid throughout the year. For employees, this is accomplished through withholding from each paycheck. If withholding is insufficient, an employee can increase the amount withheld by adjusting Form W-4.

However, additional planning may be necessary when income is received without sufficient withholding. This could include self-employment income, investment income, retirement distributions, rental income, or other sources.

Caution: Generally, taxpayers may need to make estimated tax payments if they expect to owe at least $1,000 after considering withholding and refundable credits.

Estimated payments are generally made four times throughout the year: April, June, and September of the tax year, and January of the following year. This makes reviewing your tax situation throughout the year particularly important. Waiting until your tax return is prepared the following spring may mean the opportunity to correct an underpayment has already passed.

How Much Do You Need to Pay?

Fortunately, taxpayers don't necessarily need to predict their final tax liability down to the dollar to avoid an underpayment penalty. Taxpayers can avoid the penalty if their withholding and estimated payments equal at least:

• 90% of the current year's tax liability

• 100% of the previous year's tax liability

For certain higher-income taxpayers, the prior-year threshold increases to 110%, which many tax preparers use to reduce the risk of penalties.

These rules, commonly referred to as “safe harbor” provisions, can be particularly helpful when income fluctuates from year to year.

Other Sources of Income

One of the challenges with estimated taxes is that your tax situation can change throughout the year. Consider a Roth conversion. When pretax dollars are converted from a traditional IRA to a Roth IRA, the converted amount is generally included in taxable income.

A sizable conversion could therefore create significant additional tax liability. The same concern applies to investment gains, self-employment or consulting income, rental income, and other sources where taxes may not be withheld.

This is why tax planning should be an ongoing process. A withholding or estimated payment strategy that appeared adequate in January may no longer be sufficient by September.

An IRA Withholding Opportunity

For retirees and IRA owners, another planning strategy can be particularly valuable later in the year. Federal income tax withheld from an IRA distribution is generally treated as if it were paid evenly throughout the year for purposes of determining an estimated-tax underpayment, even if the withholding actually occurs late in the year. Why does this matter?

Assume a retiree reviews their tax projection in November and discovers they are $10,000 short of the amount needed to satisfy their safe harbor. Making a $10,000 estimated payment at that point can reduce the amount ultimately owed, but because the payment wasn't made until November, it may not adequately amend an underpayment from earlier in the year.

If that individual is already planning to take an IRA distribution, there may be another option. The retiree could have $10,000 withheld from the IRA distribution for federal income taxes. Because IRA distribution withholding is generally treated as paid throughout the year, it may help address an earlier underpayment and potentially reduce or eliminate an underpayment penalty.

This can be particularly useful for someone taking a required minimum distribution or otherwise planning an IRA withdrawal before year-end.

Conversely, that doesn't mean someone should take an unnecessary IRA distribution to generate withholding. Traditional IRA distributions are generally taxable and can affect other areas of your financial plan. Instead, this strategy may be most useful when the distribution has already occurred, and additional tax payments are needed.

Bottom Line

Tax planning doesn't stop when your tax return is filed. Changes in income, investments, retirement distributions, and other financial decisions can alter your tax liability throughout the year.

If you're uncertain whether you've paid enough, or which payment strategy is appropriate, coordinate with your tax advisor and financial planner before year-end. A little planning today may help avoid an unwanted surprise when tax filing occurs.

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