Advice: Taxes

Estimated Tax Strategies for Retirees

Paying estimated taxes is a trap for many retirees. Most had income taxes withheld from paychecks while they were working. Once retired they are responsible for ensuring taxes are prepaid on their investment income, IRA distributions, and other sources of income. If the payments are late or not high enough, penalties can be imposed. If the payments are too high, the retiree makes a tax-free loan to the government.

If you expect to owe more than $1,000 in federal income taxes that are not prepaid through withholding, you have to make quarterly estimated tax payments. The first quarter's payment is due by April 15. The other three payments are due June 15 September 15 and the following January 15. (If the deadline falls on a weekend or holiday, it is extended to the next business day.)

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The penalty for late or low payments is interest compounded daily at a rate announced by the IRS each month. The interest rate changes with treasury rates in the markets. Interest is charged from the day the payment was due until the earlier of the date the tax return for the year is due and the date the payment actually is made.

Estimated tax payments must cover all types of tax due: income, self-employment, and any others that will be reported on Form 1040. You make estimated payments by projecting your income tax for the year, dividing the total by four, and paying that amount each quarter.

The first goal is to make payments that will avoid any penalties. There are three 'safe harbors' under which you can try to qualify to avoid penalties for underpaying estimated taxes:

  • Pay at least 90% of the current year's tax liability through timely estimated tax payments;
  • Pay an amount equal to at least 100% of last year's total tax bill through estimated tax payments this year; or
  • If you are a 'high income taxpayer,' pay an amount at least equal to the lesser of (1) 90% of this year's tax liability or (2) 110% of last year's tax liability. A high income taxpayer is one whose adjusted gross income on last year's tax return was over $150,000 ($75,000 for married individuals filing separately).

Another way to avoid an underpayment penalty is through the "annualization method." For example, if your payments for the first three quarters of the year were accurate based on the income to date, but you had an increase in income during the last quarter of the year, you can make a higher payment for the fourth quarter and avoid a penalty. This method is for anyone whose income varied during the year and who made payments based on the income as it actually was received. To use this method, you must file form 2210 with Form AI as part of your tax return for the year. This form requires you to show when the income was received during the year and demonstrate that your quarterly estimated payments were accurate for the income received each quarter. The total payments also must equal at least 90% of this year's tax liability.

You cannot avoid penalties by paying the year's taxes with a big check in the last quarterly payment. The IRS expects you to pay the taxes equally throughout the year. If your estimated payments are not equal, the only way to avoid penalties is to use the annualization method.

Most seniors can use a little-known strategy to avoid this hassle and expense. You can have taxes withheld from IRA distributions or other payments. The withholding can take the place of estimated tax payments.

The tax law states that withheld taxes are considered to be paid evenly during the year, regardless of when they were withheld or paid to the IRS. That means to avoid underpayment penalties, all you have to do is make sure that by the end of the year enough income taxes are withheld from payments to you and paid to the IRS.

Most people realize that this rule applies to wage withholding. They do not know that it applies to withholding from any payments. For example, when taking IRA distributions, you can instruct the IRA custodian to withhold enough to cover all your income tax obligations for the year. You can do the same with annuity payments or with payments from anyone else who will send you a Form 1099 or W-2 after the year ends.

Most retirees have the payer withhold the minimum amount required by IRS regulations or ask for nothing to be withheld. That puts the burden of quarterly estimated taxes on the retiree. The burden can be shifted by instructing payers to withhold amounts that will cover your taxes for the year.

There is one catch to avoid. The tax code says withheld tax payments are not considered made equally on the estimated tax due dates during the year when the taxpayer determines the dates on which the money actually was withheld.

If you take periodic IRA distributions during the year and have taxes withheld each time, you shouldn't have a problem. But suppose you have no taxes withheld during the first 11 months, then have a large amount withheld in December. The IRS then might choose to treat all the taxes as paid on the last estimated tax payment date for the year. You would owe penalties for not pre-paying evenly during the year.

What if you have only one payment made during the year? Suppose you have one large IRA distribution made in December. You estimate the total tax burden for the year or the amount you need withheld to avoid underpayment penalties. Then, you have the IRA custodian withheld enough from the distribution to cover the taxes, even if it is most of the distribution.

Before executing this strategy, check with your IRA custodian. Some place restrictions on withholding, such as withholding a maximum percentage from each IRA distribution.

If you want to avoid penalties for underestimated taxes and also avoid the chore of preparing quarterly estimated tax payments, have enough income taxes withheld from IRA distributions, annuities, and other payments to at least equal last year's taxes.

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