By Natalie Michalek, CFP®, J.D.
- The United States income tax is a pay-as-you-go tax, which means that tax must be paid as you earn or receive your income during the year. There are two ways to pay as you go: one is through tax withholding and the other is through estimated tax payments.
- Although about 40 states and the District of Columbia (and some municipalities, too) have estimated tax rules, this article discusses federal tax only. This article is designed to apply to a calendar-year individual taxpayer, and assumes the planner has already discussed the timing issue of income realization.
- The safe-harbor rule is that individuals must pay the lesser of 100 percent of last year's tax liability (or 110 percent if an individual taxpayer's income for the prior year exceeded $150,000, or $75,000 if the taxpayer's filing status for the prior year was married filing separately), or 90 percent of actual tax liability. The 90 percent test is a projection and can lead to inaccurate forecasts, resulting in an underpayment penalty.
- Other than applying an overpayment, or making an estimated payment, there are three general methods to reduce or eliminate the penalty: (1) annualize income, (2) allocate withholding, or (3) both.
- Clients may decide the opportunity cost is too great to make the estimated payment. A financial planner can add great value to client service by recognizing and notifying the client when this issue is relevant, either by proactively making cash available, or coordinating known taxable events to reduce the penalty.
The United States income tax system is a pay-as-you-go tax, which means that tax must be paid as you earn or receive your income during the year. There are two basic ways to pay as you go: one is through tax withholding and the other is through estimated tax payments. Either way, you must generally pay in at least 90 percent of the tax owed on a quarterly basis. (Note: The tax owed may be tentative minimum tax if the client is subject to the additional alternative minimum tax, or AMT).1 An exception to the general rule is the safe-harbor withholding amount. Most employed individuals meet the safe-harbor rule by paying in 100 percent of the prior year's tax (or 110 percent of last year's tax liability if an individual taxpayer's income for the prior year exceeded $150,000, or $75,000 if the taxpayer's filing status for the prior year was married filing separately). Basically, if you make at least as much money as you did last year, and your withholding-to-income ratio remains relatively stable, you should meet the 100 percent (or 110 percent) test.
A client's first encounter with an under-withholding penalty usually occurs in the year when income (and thus associated withholding) drops significantly, and the 90 percent test applies. This penalty is calculated and added to the final tax liability on the filed individual income tax return. The magnitude of the penalty depends on the magnitude of the amount under-withheld, and the length of time owed. Surprisingly, a return can show a refund, but still reflect an underpayment penalty, since the payments are due quarterly.
For example, a client may earn a bonus related to one year that is paid in the following year. Assume the year 2007 bonus (paid in 2008) is lower than the year 2006 bonus (paid in 2007). As a result, assume that the taxpayer's anticipated withholding for 2008 will be less than his tax liability in 2007, and the taxpayer cannot meet the safe-harbor tax rule. The taxpayer must therefore pay in at least 90 percent of the tax owed, and the 90 percent test must be met for each individual quarter. In this case, "tax quarter" is defined as the tax periods ending March 31, May 31, August 31, and December 31. Estimated taxes related to each quarter are due April 15, June 15, September 15, and January 15 (the following year). The January payment may be waived if the final return and any balance due are filed by early February—February 2, 2009, for 2008 estimated taxes.
The default assumption is that one-quarter of income and withholding applies to each tax quarter, and estimated payments relate to the quarter in which they are made.2 A proactive taxpayer can alter the default and elect to annualize income or allocate withholding or do both. Form 2210 is well-known in the tax preparation world as the form containing the underpayment penalty (penalty) calculation for Forms1040 and 1041.
The tax preparer can attach a Form 2210 electing an alternative method of annualizing income or allocating withholding. However, most individuals do not proactively file Form 2210, but rather receive a tax notice notifying them the Internal Revenue Service has calculated the penalty for them. Even the IRS understands how difficult it is to calculate since it allows various ways to calculate the penalty.3
Three alternative methods attempt to create a "mismatch" in income and withholding to delay underpayments to later quarters, and to reduce the additional amount needed to meet the 90 percent quarterly test. These actual calculations are difficult at best, and a tax practitioner should have the software to model with certainty the most appropriate method for your client. But there are some general income patterns that every planner can spot, and thus bring value to the client relationship. This is especially important when a planner has conducted an income timing discussion, or is at least aware of the income timing. The last thing a planner wants to hear is, "Why didn't you tell me (or alert my accountant) that I was going to have to pay a penalty?"
This method is helpful when income varies from quarter to quarter, especially when more income is received later in the year. If you know that the client received a large capital gain, bonus, exercised stock options, or sold an apartment building, for example, in the last quarter of the year, this method may be appropriate. By using the default method, the client may actually pre-pay tax in the earlier quarters, and the excess is applied to future quarters. When annualizing income, the client must claim all income and deductions in the proper tax quarter—there is no room to pick and choose. For example, capital gains distributions for mutual funds and real estate tax payments usually occur in the fourth quarter. Each charitable deduction must be allocated to the proper quarter. Understandably, this method requires a great deal of effort and may not be cost effective, but it is the safest method to ensure no penalty throughout the year, since it's a true representation of each quarter's net income.
Example: Assume your client's 90 percent test for 2008 requires $45,000 withholding (the default is then $11,250 per quarter). The actual tax liability in total is going to be $50,000. The client's actual withholding is $40,000 ($10,000 per quarter). There is a large short-term capital gain in the fourth quarter responsible for 25 percent of the $50,000 tax liability. The default would be a $1,250 deficit for each quarter ($11,250 – $10,000) and a $266 penalty if the tax due is paid April 15, 2009.
However, if the income is annualized, there would only be a deficit from the fourth quarter and the 90 percent test for the quarters would be roughly as follows:
Q1: (($50,000 – $12,500)/4)) × 90% = $8,438
Q2: (($50,000 – $12,500)/4)) × 90% = $8,438
Q3: (($50,000 – $12,500)/4)) × 90% = $8,438
Q4: ((($50,000 – $12,500)/4)) + $12,500) × 90% = $19,687
There would be excess withholding from Q1, Q2 and Q3 of $4,686 (($10,000 – 8,438) × 3) added to the Q4 withholding of $10,000, for a total of $14,686. The client must then decide whether to make an estimated payment of $5,002 ($19,687 – $14,686), or to pay a penalty of $99 if the tax due is paid April 15, 2009. Even without an estimated payment, annualization of income could potentially save the client $167 in penalty.
Allocate Withholding Method
This method is usually more helpful when a large payment is made earlier in the year from withholding, or a prior-year refund is applied. Some fairly common examples include a client who receives a large bonus, exercises a nonqualified stock option, or receives a deferred compensation payment with statutory 25 percent withholding in the first quarter. When allocating withholding, the quarter end date is actually the due date of the payment (the 15th of April, June, September, and January of the following year) instead of the end of the quarter. Because 3½ months' worth of withholding is allocated to the first quarter, this method is generally the most effective in reducing the penalty, since the later quarters receive the benefit of applying the excess in a timely manner.
Extraordinary withholding can be allocated to the first quarter, and the excess automatically applies to each successive quarter. Therefore, the client may not have an underpayment until the third or fourth quarter based on anticipated future income.
A taxpayer can choose to allocate salary withholding equally to each quarter, and the extraordinary withholding (such as on deferred compensation payments, nonqualified stock option spread, restricted stock vest, or withholding on imputed dividends) to the actual quarter paid.
Example: Your client earns a bonus related to one year that is paid in the following year. Assume the year-2007 bonus is paid in February 2008. Assume that 2008 salary withholding is estimated to be $20,000 and the 2007 bonus withholding is $7,000. Assume the 90 percent test requires $8,000 of withholding per quarter. With no estimated payments, and no allocation of withholding, your client would be short $1,250 a quarter ($8,000 – ($27,000/4)). The penalty would run from April 1, 2008, and would total about $266, assuming no estimated payments were made and that the client paid the balance due on April 15, 2009.
A simple calculation to allocate withholding would be to divide the $20,000 salary withholding by 4 for $5,000 withholding per quarter. Then allocate the $7,000 bonus withholding to the first quarter for a total withholding of $12,000 in the first quarter, and $5,000 in the second, third, and fourth quarters. If the 90 percent test requires $8,000 of withholding per quarter, the excess from the first quarter ($12,000 – $8,000 = $4,000) is applied to the second quarter. The second-quarter excess is applied to the third quarter ($5,000 + $4,000 = $9,000 – $8,000 = $1,000). There is a deficit beginning in the third quarter ($5,000 + $1,000 = $6,000 – $8,000 = –$2,000). The deficit for the fourth quarter would be ($5,000 – $2,000 – $8,000) = –$5,000). The client would then decide whether to make a third- and fourth-quarter estimated payment for this deficit, or to pay the associated penalty of about $152. Even without an estimated payment, allocation of withholding could potentially save the client $114 in penalty.
But unexpected income could increase the 90 percent threshold, resulting in a penalty, so this method is not foolproof. Furthermore, you cannot apply a payment to a previous quarter if you are wrong.
Example: Your client's accountant gave her pre-filled estimated payment vouchers in April that she dutifully and timely filed. She made four quarterly estimated tax payments of $4,500 per quarter to cover 90 percent ($18,000) of her estimated $20,000 tax liability in a year when the prior-year safe harbor wasn't feasible. In retrospect, $25,000 was required to cover 90 percent of her $27,778 tax liability because her base salary increased in June, so she should have paid an additional $1,750 per quarter. The amount of her underpayment is $1,750 for the period from April 15 to June 15, $3,500 from June 15 to September 15, $5,250 from September 15 to the following January 15, and $7,000 from January 15 until the earlier of the filing date, or April 15, when she files her return with payment. The underpayment penalty would be roughly $372.
The taxpayer could also choose to allocate all withholding and payments, but would need access to all paychecks with withholding details in this case. A good tax practitioner will run this combination of methods to see if it yields any lower penalty, or required payment. This has fairly limited applicability, and generally the above two methods are the most effective. Sometimes there is no way to reduce the penalty, especially if equally weighted extraordinary income occurs in both the first and fourth quarters.
The penalty amount is the underpayment for a particular quarter, multiplied by the current penalty interest rate (8 percent for the first quarter of 2008), multiplied by the ratio of number of days late, divided by 365. The current rate is adjusted quarterly and is based on the prime rate plus 2 percent.
Many times the magnitude of the penalty is small in relation to total tax owed. If a taxpayer underpaid estimated tax in the first quarter by $5,000, and that amount remained static throughout the next three quarters, the penalty would be roughly $5,000 × .08 × (275/365) = $301. (The actual calculation multiplies the deficit in each quarter multiplied by the number of days in each quarter.)
In fact, even if the client knew about the penalty possibility, the client may decide that prepaying through estimated tax payments is not a good use of money. $5,000 compounded daily at 8 percent would be $5,416 (April 15 to next April 15). At 6 percent, it would be $5,309, the breakeven point. If you think you can earn 6 percent after-tax elsewhere, you may decide not to make additional payments. You could also view it as a loan from the IRS at 6 percent. But do not make the assumption for your client that this is the best alternative. Some clients dislike paying $1 too much to the IRS even if they understand the "use of money" argument.
If you are an employee, you can adjust your W-2 withholding by reducing your exemptions, changing to the single rate, or even adding a flat amount per paycheck so that you will pay the safe-harbor amount by year end. Withholding on pension payments and IRA or qualified plan distributions is assumed to apply to the entire year unless elected otherwise. This type of withholding can also be used to meet the safe-harbor test.
Remaining underpayments after application of the above three methods are met with estimated payments, either with a Form 1040ES voucher or electronically with the electronic federal tax payment system. You can also now pay with a credit card.4 If any penalty remains after estimated payments, it will be reported on page two of Form 1040 and added to regular tax liability.
Some clients think that if they miss the April 15, June 15, September 15, or January 15 deadlines, it's too late, and they wait for the next quarter. But since the penalty is calculated by the number of days late, it's never too late to make the payment; it is simply applied first to the previous quarter. Clients can use any voucher no matter what quarter is printed on the voucher.
Clients often value financial planners for their investment, economic, and risk management advice. Planners also tend to relay the same topical information to all clients, especially in their area of expertise and background. But a basic understanding of the tax and cash flow implications of a client's actions is still required to maintain a dynamic practice. Most clients would appreciate and value your coordination with their tax professional as a result of a realized gain you executed, or the sale of a business property you discussed. Proactively raising the issue of cash needed for estimated payments instead of automatically reinvesting cash can also reinforce a planner's fiduciary adherence and substantive knowledge. Fostering a closer relationship with a tax professional is in the best interest of both your service delivery and perceived value.
Natalie B. Michalek, J.D., CFP®, joined the Nautilus Group in 2007 after a seven-year career in financial planning, counseling high net worth executives. Her background includes risk management, investment management, executive benefits, estate planning, and income tax. Her advice and articles have been featured in national media outlets.
- Exceptions to penalty include (1) no tax liability in prior year, (2) certain trusts and estates have a two-year exemption, (3) specific rules for farmer and fisherman, or (4) total tax due is less than $1,000. The penalty can also be waived if the failure to make estimated payments was caused by a casualty, disaster, or other unusual circumstance and it would be inequitable to impose the penalty. In addition, the penalty can be waived if the taxpayer retired (after reaching age 62) or became disabled in the preceding tax year or during the tax year for which estimated payments were required to be made, and the underpayment was due to reasonable cause rather than willful neglect.
- Late payments are first applied to the underpayment balance for previous quarters even if you specifically designate a particular quarter.
- 2006 Instructions to Form 2210, p. 1.