Some people can avoid having to make estimated tax payments by increasing their withholding.
You can use extra withholding on one type of income (such as wages) to avoid paying estimated tax on another type (such as interest, dividends or capital gain). And there’s a special benefit to this approach: extra withholding that comes late in the year is treated the same as if it was spread evenly over the year. You can use this approach to avoid late payment penalties.
Increasing your withholding
To increase the amount of federal income tax withheld from your paycheck, file a new Form W-4 with your employer. You’re required to fill out this form when you start working for an employer, and you can fill out a new one whenever your circumstances call for a change in the amount of withholding.
Earlier versions of this form asked you to translate changes in income or deductions into a number of allowances. That confusing approach has been eliminated. The form now has a relatively straightforward section called “Other Adjustments.” It offers two ways to increase your withholding.
You can state the amount of other income you have that isn’t subject to withholding. For example, if you expect to have $15,000 in interest income, you can enter $15,000 on this line. Bear in mind that this approach will produce roughly accurate withholding only if your W-4 takes effect very early in the year. If you file this form with your employer in June, you may get only half the amount of additional withholding you need.
The other way to increase your withholding is even simpler. You can state an additional amount of tax you want withheld each pay period. As explained below, this approach is particularly helpful when making a late-year change to avoid a penalty for failing to make adequate quarterly estimates earlier in the year.
Check with your employer to find out when the change will go into effect. Normally there’s a time lag between the day you fill out this form and the day it’s processed, so you may not see the change in your very next paycheck. Keep an eye on your paycheck stubs to confirm that the change was properly made and had the effect you anticipated.
Be careful here. When you file this form with your employer, you’re saying you want this additional amount withheld until further notice. If you don’t want the increased amount withheld in the following year, you need to file another form eliminating the extra withholding. Again, check with the payroll department to find out when you need to file this so that it takes effect for the first pay period — not earlier, because you’ll be underpaid for this year, and not later, because you’ll be overpaid for next year.
Avoiding late payment penalty
The nice thing about using withholding to cover your estimated tax liability is that it can get you out of a late payment penalty. Withholding is presumed to be received evenly throughout the year.
Example: Suppose you realize in May that you need to pay $6,000 estimated tax for the year, and you’ve already blown the first $1,500 payment that was due April 15. It won’t be a big deal if you send in the payment a few weeks late because the penalty is based on the amount of time the estimate was late (see Penalty for Underpayment). But you can avoid the penalty altogether by increasing your withholding for the rest of the year by $6,000. The IRS will treat the withholding as if it occurred evenly throughout the year, with $1,500 coming in the first quarter.
Although the IRS is required to treat your withholding as if it came in evenly throughout the year, in appropriate circumstances you’re permitted to demonstrate that the opposite is true. For example, if you had lots of withholding during the first quarter of the year and smaller amounts later, you can take advantage of this fact to reduce a penalty that would otherwise apply in the first quarter.