Tax planning and compliance for investors
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An overview of rules for making payments of estimated tax.
The federal income tax system is a "pay as you go" system. In general you're required to pay tax over the course of the year rather than waiting until April 15. Most people meet this requirement without really thinking about it because of tax that's withheld from their wages. But if you have significant amounts of investment income (or other types of income that aren't subject to withholding) you may incur a penalty if you don't make quarterly payments of estimated tax.
The general rule is you have to pay estimated tax if your withholding doesn't cover 90% of your tax liability. But there are exceptions:
The second exception is particularly important. If you receive a large amount of investment income in one year — for example, you sell stock at a large gain or make a rollover to a Roth IRA — you may not be required to pay estimated tax even though you owe a great deal of tax that year. You may be able to delay your tax payment until April 15 because of the exception for the prior year's income.
You won't get this free ride the following year, though. Now you'll be looking back at a year in which your income was higher. If you have two years in a row when you have income that isn't subject to withholding, you probably have to make estimated tax payments for the second year.
Details: Who Must Pay
You figure the amount you need to pay the same way you determine whether you need to pay. It's the difference between the amount of withholding and credits you would need to have to avoid making payments, as described above, and the amount of withholding and credits you actually have, with one exception: you don't get the benefit of the $1,000 rule mentioned above once it's determined that a payment is required..
The amount you have to pay is usually pretty easy to determine if you're basing your payments on the prior year's tax liability. Figuring the payment based on 90% of the current year's tax liability is more difficult — which is why most people try to avoid that approach.
Details: How Much to Pay
Some people choose to make estimated tax payments even when the payments aren't required. This approach deprives you of the opportunity to earn interest on the amount you prepaid, but assures that you won't have a crushing tax bill on April 15.
Details: Voluntary Payments
In many cases where you would otherwise be required to make estimated tax payments, you can avoid that process by increasing your withholding. Request the appropriate form from your employer and fill it out in a way that will cause an additional amount to be withheld from your paycheck.
Details: Increasing Your Withholding
If you're unfamiliar with this process, you'll be pleased to learn how easy it is. You don't have to explain to the IRS how you arrived at the amount you're paying. The form you fill out is minimal, basically telling the IRS who you are and what you're paying. The only parts that are sometimes hard:
Your payments for each year are due on the 15th day of April, June, September and the following January. Notice that although they're considered quarterly payments, they're not all three months apart. Any payment that falls on a weekend or holiday is due the first non-holiday weekday after that date.
Reminder: If you're required to pay federal estimated tax, you may also be required to pay state estimated tax.
Details: Making Estimated Tax Payments
Don't panic if you have an underpayment. The penalty is equivalent to interest on the amount of the underpayment. It's best to avoid the penalty, but the penalty will be minimal if the underpayment is small or is corrected within a short period of time.
Details: Penalty for Underpayment
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