United States: Start The Year Right: Review Withholding And Estimate Tax Payments

Last Updated: January 12 2018
Article by Adam Levine, CPA

Has this ever happened to you? Income tax time rolls around and you realize that over the course of the year, you haven't withheld enough or failed to make estimated tax payments that you should have. You now owe the IRS money, even before factoring in underpayment penalties and interest.

Many taxpayers make this mistake, but it can easily be avoided. Taxpayers should review their withholding and submit quarterly tax payments when necessary. Here's why this is smart.

Adjust to Fit

IRS withholding tables are designed to approximate a typical worker's tax liability for the year, but not all workers are typical. Depending on your earnings, marital status and other tax circumstances, following the tables may result in underpayment or overpayment. A more reliable approach is to determine your actual expected tax liability regularly and adjust your withholding amounts by completing a new Form W-4.

You should also revisit your withholding amounts after certain life changes that affect your tax liability. Examples include a new job, marriage, divorce, unemployment and the birth of a child.

Generally, you are required to make estimated tax payments if you have income that is not subject to withholding and you expect to owe $1,000 or more in federal taxes after taking into account withheld taxes and credits. To meet estimated tax obligations, figure out your expected tax liability for the year, subtract expected withholdings and credits, and pay the remainder in four equal installments on or before April 15, June 15, September 15 and January 15. (If the 15th falls on a weekend, the payment due date generally is the following business day.)

The Problem With Estimates

You will be subject to underpayment penalties if your total withholdings and timely estimated tax payments are less than 90% of your tax liability for the year (unless you owe less than $1,000 in taxes). Penalties may also apply if you skip or underpay an estimated tax installment, even if your remaining installments cover your entire tax liability. Suppose, for example, that your estimated tax liability for the year is $30,000. If you skip the April payment and pay $10,000 on the following three due dates, you will owe penalties for skipping the first installment, even if your remaining payments cover your entire tax liability.

The problem with estimated taxes is that they are just that—estimated. Income can be unpredictable and if you receive unexpected income, you can easily fall short of your tax obligations.

Two Methods

Fortunately, there are strategies you can use to avoid penalties. If you receive income unevenly during the year, use the annualized income installment method to match your estimated tax payments to your actual income, deductions and other tax attributes during each period. This method is a bit complicated. Essentially, it requires you to determine each estimated tax installment based on the amount that would be due if your tax liability through the most recent period was annualized. However, it is worth calculating because the method may enable you to reduce or eliminate underpayment penalties.

Alternatively, you can use a safe harbor method. Under the safe harbor method, you will not owe penalties if you pay 100% of last year's tax liability in four equal installments. The amount increases to 110% if your adjusted gross income last year was greater than $150,000 ($75,000 for married couples filing separately). Generally, the safe harbor is the simplest way to ensure that you will not owe estimated tax penalties. However, keep in mind that if your income declines this year, you will end up overpaying. Additionally, if your income increases substantially this year, you will not owe penalties, but you will have to pay by the April due date to cover additional tax.

What if you discover during the year that you have not paid enough in estimated taxes? Consider increasing withholding from your wages (or your spouse's wages) to make up the difference. Although increasing your estimated tax payments late in the year will not necessarily help you avoid penalties, withholdings are treated as though they were paid evenly throughout the year, regardless of their timing.

Getting Help

Because estimating tax payments can be complicated, ask your tax advisor for help. Armed with informed estimates, you can confidently adjust your withholdings and quarterly tax payments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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