At the end of last week, I mentioned that estimated tax payments for the second quarter of 2013 are due soon.
As I noted in that post, these payments are intended to help you avoid income tax underpayment penalties if you have income that isn’t subject to withholding (self-employment, investing, etc.).
In short, if you don’t pay enough into the income tax system during the year, the IRS can penalize you when it comes time to file your return. So who’s subject to these penalties and how can you avoid them?
Well… In general terms, you’ll face an underpayment penalty if the total of your annual withholding and estimated payments don’t exceed:
- 90% of the total tax owed during the year in question, or
- 100% of the total tax shown on the previous year’s return.
Note, however, that the 90% in #1 becomes 66.67% for farmers and fishermen. Similarly, the 100% in #2 becomes 110% if your AGI is above a certain threshold (over $75k/$150k for single/married filing jointly in 2012). Full details can be found in Chapter 4 of IRS Publication 505.
If you won’t hit these levels via standard withholding, then you’ll need to make estimated tax payments. If you will hit these thresholds, then you’re welcome to underpay throughout the year and then just pay the difference at the end. Back when interest rates were higher, this sort of strategy could be quite profitable.
Assuming that you wind up making quarterly payments, keep in mind that the IRS will expect you to make approximately equal payments across the four quarters. There are, however, exceptions if your income is uneven.
Protip: If you realize late in the year that you may be facing penalties, it might be possible to increase your withholding to fill the gap. Unlike quarterly estimated payments, standard withholding is treated as if it was paid in evenly throughout the year even if it all came in at the end.
If you miss a payment, you will be charged an underpayment penalty from the date the payment was due until the date it was received. The penalty can be calculated using the worksheets associated with IRS Form 2210.
The primary exceptions to these rules are for those who owe less than $1000 in taxes when all is said an done (i.e., your total tax bill – [withholding + payments] < $1000) and/or those who had no tax liability in the previous year. In those two specific cases, no underpayment penalties will be assessed.