There is no good reason for paying your taxes early. But there is a good reason to avoid underpaying your taxes, specifically your quarterly estimated taxes. Penalties are assessed for underpayment, even if the underpayment is unintended.
Here are three tips that may help you avoid the unpleasant surprise of being assessed a costly penalty for tax year 2012.
Tip #1. Increase End-of-Year Withholding Taxes
Federal withholding taxes are treated as having been made equally throughout the year, regardless of the actual amounts paid each quarter. This treatment gives employees the opportunity to avoid an estimated income tax penalty through planning and larger contributions at the end of the year.
If your estimated tax payments for the current year are too low, you can avoid the tax penalty simply by increasing the withholding on your year-end paychecks (or, if applicable, your year-end bonus).
For example, suppose in 2012 you make quarterly estimated tax payments of $5,000. But near the end of the year, you realize that the actual payment should have been $5,500. (Maybe you made a mistake or had some unexpected additional income.) To avoid the tax penalty, you could withhold an extra $2,000 from your paychecks by the year-end. That extra $2,000 will be treated as having been paid at a rate of $500 per quarter (for the necessary $5,500 per quarter), and the underpayment penalty from each quarter will be eliminated.
This tip is often used by owners of Subchapter S Corporations. During the year, the business owners may have little or no federal withholding tax taken out of their salaries. In December, however, they can give themselves a bonus and withhold the entire amount, thus avoiding a tax penalty.
Tip #2. Withhold Taxes from Your Required Minimum Distributions (RMDs)
Older taxpayers are required to take distributions from their IRAs. However, those who don’t need to spend their RMDs can use those distributions to have their taxes partially or entirely withheld. This tip can help reduce or eliminate the need to make estimated tax payments during the year.
Taxpayers may choose to withhold as much or as little of their RMD as they desire. All of the IRA custodians include a federal withholding option on their IRA distribution form. Tax withholdings from RMDs are treated the same as tax withholdings from salaries and wages. These amounts are deemed to have been paid evenly throughout the year, even if paid from a distribution that occurs on December 31, 2012.
Tip #3. Take Your IRA Distribution and Replace It Within 60 Days
What if you have no salaried job from which to have federal taxes withheld? So long as you have an IRA, you might be able to avoid an underpayment/estimated tax penalty. Taxpayers are permitted to take a distribution from their IRA at any time, regardless of age. If under age 59½, taxpayers can avoid a 10% early distribution penalty if they replace their IRA funds used for taxes within 60 days.
For example, suppose in December of 2012, you realize you should have paid $1,500 in estimated tax payments during each of the first three quarters of the year. By December 31st, you could take a $6,000 IRA distribution and earmark the entire distribution for federal tax withholding. The withholding will be treated as being paid $1,500 per quarter, eliminating the estimated tax penalties. Then, within 60 days, you can replace the $6,000 back into your IRA from other assets (like a savings account or a taxable brokerage account), resulting in a tax-free rollover.
Note: If you already did a previous rollover into or out of that same IRA account within the past 365 days, the second distribution will not be eligible for a tax-free rollover! There is a once-per-year IRA rollover rule that could trigger a tax liability (and a possible 10% penalty if you are under age 59½).
Taxpayers don’t like unpleasant surprises. Being aware of these three tips could help you avoid paying an underpayment/estimated tax penalty. -CL-
Note: Please consult with a competent tax professional before implementing any of the above tips.
Charles Welde, CPA, CFP® is a member of Ed Slott’s Master Elite IRA Advisory Group and President of The CP Welde Group, Tax and Wealth Advisors, 330 Kennett Pike, Suite 201, Chadds Ford. 610-388-7705;.CPWelde Group.com.