Every year, unwary taxpayers end up owing the Federal government hundreds of dollars in underpayment penalties for failing to properly pay estimated taxes. The purpose of this article is to educate you on estimated taxes and underpayment penalties: What the requirements are, when penalties are assessed, and how to avoid them.
The United States income tax system is a pay-as-you-go tax system, which means that you must pay income tax as you earn or receive your income during the year. For taxpayers that are employees, this generally isn’t a problem because taxes are withheld from your regular paycheck. Therefore, you are automatically paying in taxes as you earn money, and you do not need to worry about underpayment penalties unless you are earning significant money outside of your regular job.
However, if you are self-employed, or have business interests that generate large amounts of taxable income outside of your regular employment, then you may be required to make estimated tax payments. Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed. If you do not make these payments, you will be subject to underpayment penalties.
Estimated Tax Requirements:
For the IRS (not California – see below for that), your payments should be made in 4 equal installments, which are due on April 15th, June 15th, September 15th, and January 15th of the following year. So, your first estimated tax payment for 2017 will be due on April 15th, 2017.
Pro-Tip: If you are going to file for an extension and pay money in, include your first quarter estimated tax payment in your extension payment. You can always retroactively apply money you paid in with your extension to your estimated tax payments, but you cannot apply estimated tax payments to your extension payment. Therefore, paying both your extension and your first quarter estimate with your extension payment gives you more flexibility if you miscalculated on your extension payment.
How Much To Pay In:
For the IRS, if you expect to owe $1,000 or more in taxes, then you need to make estimated taxes that are equal to the lesser of the following:
- 90% of your current year tax
- 100% of your prior year tax
However, if your adjusted gross income (AGI) was more than $150,000 (or $75,000 for married filing separately) in the prior year, then there are different rules:
- 90% of your current year tax
- 110% of your prior year tax
For the IRS, these payments should be made in equal installments. If your income is lumpy (for example, if you are a real estate agent and receive large commission checks unpredictably through-out the year), then special rules apply. However, 110% of your prior year tax is a safe harbor amount that will avoid penalties no matter what.
California complies with Federal rules regarding the amount of estimated tax payments (90% / 110%). The only difference is that if you make more than $1,000,000 in California AGI, you are required to make estimates based upon your current year income (meaning they take away the safe harbor for 110% of prior year tax).
However, where the FTB differs from the IRS is for when they want their tax payments. California front loads the tax payments, so instead of paying 4 equal installments throughout the year, you must pay according to the following schedule:
- 30% in Q1 (April 15th)
- 40% in Q2 (June 15th)
- 0% in Q3 (September 15th)
- 30% in Q4 (January 15th)
As you can see, California likes to make things difficult.
What if I Make Money in Large Unpredictable Chunks?
If you make money in large unpredictable chunks, generally speaking, your best bet is to pay in 110% of your prior year tax, since that is an easy safe harbor to comply with.
However, that may not be possible. For example, in my former employment we had a client who received a huge commission check in October, but made virtually no money up to that point and didn’t have money to make estimated tax payments. In that case, you can use the annualized income installment method to avoid penalties. This can get complicated, so contact me if you are in this position and need help avoiding penalties.
How Much Are Underpayment Penalties?
They can be significant. If you want to calculate your underpayment penalty, you can fill out IRS Form 2210. It is not uncommon to see penalties in the hundreds of dollars for failing to make proper underpayment penalties. I have seen underpayment penalties in the thousands. So, it is important to get on top of estimated tax payments in order to avoid unnecessary penalties.
Can Underpayment Penalties Be Waived?
Generally, no. There are two exceptions:
- You did not make a required payment because of a casualty event, disaster, or other unusual circumstance and it would be inequitable to impose the penalty, or
- You retired (after reaching age 62) or became disabled during the tax year or in the preceding tax year for which you should have made estimated payments, and the underpayment was due to reasonable cause and not willful neglect.
The first case is a “facts and circumstances” type case. You may be able to get relief from penalty by appealing to the IRS via a written letter. However, in general, the IRS and FTB are very reluctant to waive underpayment penalties.
Underpayment penalties can be significant. The best strategy for avoiding them is to make sure that you are making estimated tax payments during the year. If you need help with your estimated taxes, contact me and I can assist you.