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Tax planning is an important component of financial management, yet it is typically overlooked by many taxpayers. The handling of projected tax payments and the resulting penalties for underpayment is a common source of uncertainty and financial pressure. Understanding the subtleties of anticipated tax safe harbors, the necessity for ratable payments, and penalty mitigation measures may all have a substantial influence on a taxpayer's financial health. This essay goes into these issues, providing guidance on how taxpayers might efficiently negotiate these problems.
Underpayment penalties may catch taxpayers off guard, particularly if they fail to make the appropriate estimated tax payments. The IRS uses these fines to promote regular tax payments throughout the year rather than a single big amount at the end. The penalty is simply an interest charge on the amount of tax that was due but not paid throughout the year. This penalty may be severe, particularly for persons with changing wages or who see a big gain in income without properly modifying their expected payments. While most wage earners have enough tax withheld from their paychecks to avoid the underpayment penalty, individuals with investment income or side jobs may discover that their withholding is insufficient to fulfill the prepayment requirements and avoid a penalty.
The IRS determines the interest rate for underpayment penalties every quarter. It is equivalent to the federal short-term interest rate + 3%. With the recent quick increase in interest rates, the underpayment interest rate for each quarter of 2024 is an astounding 8%, the most it has been in over two decades. Something to be worried about if you anticipate your withholding and estimated tax payments to be significantly underpaid.
Individuals use Form 1040-ES to make payments on a "quarterly" basis.
Individuals and some other taxpayers' anticipated tax payment schedules do not correspond to the calendar year's even quarters. This is mostly owing to the IRS's precise due dates for these payments. For 2024, the expected tax payments are due on the following dates:
1. First Quarter: Payment is due April 15, 2024. This payment covers money generated between January 1 and March 31.
2. Second Quarter: Payment is due June 17, 2024. This payment covers money generated between April 1 and May 31. This period is just two months long, which adds to the uneven character of the quarters.
3. Third Quarter: Payment is due September 16, 2024. This payment covers money generated between June 1 and August 31.
4. Fourth Quarter: Payment is due January 15, 2025. This payment includes money received throughout the four months from September 1 to December 31.
These payment due dates are typically on the 15th of the month. However, if the 15th occurs on a weekend or holiday, the deadline is extended to the next working day.
Safe harbor regulations allow taxpayers to avoid underpayment penalties and the need to forecast the anticipated tax for each payment period. These guidelines specify the minimum amount that must be paid to avoid fines. In general, taxpayers may avoid fines if their overall tax payments equal or exceed:
Pay 90% of the current year's tax obligation or 100% of the previous year's tax liability.
However, for higher-income taxpayers with an adjusted gross income (AGI) of more than $150,000, the safe harbor level of 100% rises to 110% of the previous year's tax due.
One important feature of anticipated tax payments is the need that they be paid ratably throughout the year. To avoid fines, taxpayers should make equal contributions every "quarter". Income is not usually distributed equally throughout the year, which complicates this need. For example, if a taxpayer gets a large chunk of their income in the later half of the year, they may be underpaid in previous quarters, resulting in penalties.
Understanding how fines are assessed may help to solve the issue of unequal income. The IRS calculates penalties quarterly, which means that underpayments in one quarter cannot be offset by overpayments in a subsequent quarter. This might be especially difficult for those with seasonal or intermittent incomes. To help alleviate this, individuals may utilize IRS Form 2210, which enables them to annualize their income and possibly decrease or eliminate fines by demonstrating that their income was not distributed equally throughout the year.
Raise Withholding - One effective way to avoid underpayment penalties is to raise withholding for the remainder of the year. Unlike projected payments, withholding is treated as paid ratably throughout the year, regardless of when the tax is actually withheld. This implies that raising withholding later in the year may assist to offset any deficiencies from previous quarters.
Another method is to take a large dividend from a retirement plan, such as a 401(k) or 403(b), which is subject to a 20% withholding obligation. The taxpayer may then roll the distribution back into the plan within 60 days by using other money to cover the part of the dividend that was withheld. Tax withholding may also be done on conventional IRA distributions, but this method needs careful planning to maintain compliance with the one IRA rollover per 12-month period limitation.
Annualized exemption - For taxpayers with inconsistent income, the annualized exemption on IRS Form 2210 might be a useful tool. This form enables taxpayers to compute their needed estimated payments based on actual income received in each quarter, rather than assuming equal income throughout the year. Taxpayers might possibly decrease or eliminate underpayment penalties by proving that their revenue was distributed unevenly.
Managing anticipated tax payments and avoiding underpayment penalties needs meticulous preparation and a complete awareness of IRS policies and procedures. Taxpayers may successfully traverse these obstacles by using safe harbor laws, recognizing the necessity for ratable payments, and employing techniques such as enhanced withholding and retirement plan distributions.
If you anticipate that your pre-payment of tax will be significantly underpaid and would want to design a plan to minimize or lessen underpayment penalties, please contact our office. But if you wait too late in the year, you may not have enough time before the end of the year to make any significant adjustments.
There are unique regulations for qualified farmers and fishers, who may have alternative criteria and possible exemptions for underpayment penalties; contact this office for more information.