Tax planning and compliance for investors
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Find out if you have to pay estimated tax.
The general rule is that you have to pay estimated tax if your withholding and other tax credits are less than 90% of your tax liability (including the amount of alternative minimum tax you owe, if any). But there are two important exceptions:
You don't have to make federal estimated tax payments if your tax due, after taking withholding into account, is less than $1,000.
Example: Suppose you expect your wage withholding to be just enough to cover your income tax liability. Then you have a $4,000 long-term (more than 12 months) capital gain you didn't plan on. This gain will be taxed at 20%, so the added tax is $800. You can make an estimated tax payment if you feel more comfortable doing so, but there won't be a penalty if you wait until April 15 of next year to send in the payment because it's less than $1,000.
The only problem with this rule is that sometimes it's difficult to know what your tax liability will be. But $1,000 is a reasonable amount of leeway for the majority of taxpayers.
When we talk about the tax due, we mean the total amount of tax you owe — including the dreaded alternative minimum tax (AMT).
Most people can avoid paying estimated tax if their withholding and credits equal 100% of the tax shown on the prior year's return. We call this the prior year safe harbor.
You can't rely on the prior year safe harbor if you had a short (less than 12 months) taxable year for the previous year. That's such a rarity that it's barely worth mentioning.
There's a related rule. You don't have to pay estimated tax if all of the following are true:
This rule often permits taxpayers to avoid making estimated payments if they receive a large sum of income on a one-time basis.
Example: In a normal year your withholding is enough to cover your income tax — in fact, you usually get a small refund. Then you sell your collection of rare stamps for a gain of $200,000. Despite the huge increase in income, you don't have to make estimated tax payments if your withholding will be at least equal to the tax shown on the prior year's tax return.
Certain amounts can be excluded when you determine the "total tax" on the prior year's return, but most of these items apply to a small percentage of taxpayers, or apply mostly to taxpayers who are unlikely to have to pay estimated tax. Examples are the earned income credit, social security tax on tip income, and the credit for federal tax paid on fuels. Further details are available in IRS publications and instructions. Most people simply rely on the "total tax" figure from their tax return to determine the amount of withholding and other credits needed to qualify for the prior year safe harbor.
Higher income, higher percentage. There's a rule that requires taxpayers with adjusted gross income above $150,000 on the prior year's return ($75,000 if married filing separately) to pay 110% of the prior year's tax (not just 100%) when applying the prior year safe harbor. Congress has been known to tinker with this percentage, so check the form instructions.
Once you know the amount of tax you need to cover (90% of the current year's tax or 100% of the prior year's tax), you need to see if your payments and credits will cover this amount.
Begin by looking at your paycheck stub. How much federal income tax is being withheld? Use that information to see how much will be withheld for the year and see if it covers your minimum. If so, you don't have to make estimated tax payments.
If not, consider the tax credits you're entitled to claim. Can you make up the shortfall with child care credits or the credit for dependent children, for example?
Perhaps you still have a shortfall after considering credits. You may still be able to avoid paying estimated tax by increasing your wage withholding. See Increasing Your Withholding.
If you determine that you have to pay estimated tax based on these rules, the next step is to determine how much you have to pay. Then you should consider whether it makes sense to cover that amount by increasing your wage withholding, if that opportunity is available.
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