For 3 weeks we will be covering different facets of estimated tax. Teaching you the basics, how to avoid underpayment of estimated taxes and some new strategies to replace the traditional monthly payments.
ESTIMATED TAX STRATEGIES
Taxpayers who are used to the cash flow from their salaries, pensions, or other income with taxes withheld may have trouble increasing withholding and making quarterly tax payments. The idea of making ends meet with lower net payments may sound intimidating. The same holds true for planning out quarterly estimated taxes, especially on April 15 when your estimated amount is due at the same time as any balance from your annual tax return.
For those who need alternative solutions to simple quarterly payments, the strategies below may help meet your needs:
- Tweak your withholding and double-check the results. For instance, if a taxpayer is expecting a shortfall of $5,000, they can divide that amount by the number of remaining pay periods for this tax year and ask the withholding agent to withhold the additional amount. After the change is requested, be sure to check the next paystub to ensure it reflects the amount expected.
- “Super withhold” on income you do not need for living expenses. If you are not relying on the cash flow from your traditional individual retirement account (IRA) distributions, your IRA custodian will often withhold a specific dollar amount up to 100% of your required minimum distributions (RMDs). Note that the federal and state withholding requirements may be different. Since withholding is treated as if it is evenly paid throughout the tax year, this is often a great solution to simplify tax payments.
- Break up the quarterly estimated payments into smaller amounts. If the quarterly estimated tax payment schedule does not work well for you, consider monthly or even more frequent and smaller payments that better fit your income cadence. Federal tax payments can even be made electronically through EFTPS or IRS Direct Pay. Most state tax agencies offer similar online payment options.
- Base estimated tax payments on a percentage of income payable when income is received. For self-employed taxpayers with an erratic income, monthly or weekly tax payments may not be practical, especially in months where they receive little or no income. Instead, try calculating your federal and state/local estimated tax payments based on a certain percentage of your gross receipts. If your annual amounts are similar from year to year, you can carry over the percentage from last year. If not, calculate the percentage based on your projected income for the year.
ESTIMATED TAX PAYMENTS IN PRACTICE
Read through the example scenarios below to see how different tax strategies:
Example A: Thad worked for many years as a therapist for a social services agency, but in 2010, he started his own practice. Thad did not know how to manage his tax compliance as a self-employed taxpayer, and he neglected to file tax returns for several years, resulting in tax penalties. After consulting a Certified Tax Planner, Thad filed returns for all outstanding years and negotiated an installment payment agreement (IPA). However, he still found it difficult to keep up with the IPA, so when he turned 62, his tax planner recommended taking early SSA benefits. Though this is not necessarily the best route for all taxpayers, for Thad it was a lifesaver—he requested the maximum federal tax withholding and greatly reduced his estimated tax requirement. Since then, he has successfully made monthly estimated tax payments.
Example B: Victoria owns a successful music studio, but she also has a history of balance-due tax returns due to a failure to set aside funds for her tax payments. This year, she began making monthly estimated tax payments while also paying off prior-year obligations through an IPA. Though she still needs to increase the amounts to cover her 2022 tax liability, she is expecting a divorce settlement that will pay off her prior-year tax balances and enable her to funnel money toward this year’s taxes. Her Certified Tax Planner has also provided her with a percentage method to use in case she has lean months.
Example C: Stan designs software and apps. His income is substantial, but the timing of his income is extremely variable. At the advice of his Certified Tax Planner, he has been using the percentage of gross receipts method to make estimated tax payments, adjusted each year based on his updated income. Stan has managed these payments well, and without large balances due on his tax returns, he can usually reduce his taxes by contributing the maximum amount to his simplified employee pension (SEP).
SUMMARY
While W-2 employees can often rely on their employers to withhold enough taxes to cover their tax obligations, taxpayers with more complex employment scenarios may need to use special strategies to stay on top of their tax compliance and minimize penalties. Understanding prepayment options can help you avoid large balances due on your tax returns and find the payment cadence that works best for your cash flow.
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