The Estimated Tax Trap “Snagging” More & More Retirees

A growing number of taxpayers, especially retirees, are being caught in the estimated tax trap.

When income taxes aren’t withheld, taxpayers have to prepay their federal income taxes in four estimated tax payments.

The payments are due on April 15, June 15, September 15 and January 15 (unless the due date falls on a holiday or weekend).

The estimated tax payments are supposed to be spread evenly over the year, unless the income is earned unevenly during the year.

States with income taxes have the same or similar requirements.

When timely estimated tax payments aren’t made, a penalty is imposed.

The penalty is interest compounded daily for the period the government didn’t have the money when it should have. The interest rate is set quarterly based on treasury debt rates.

Often, people don’t learn they owe the penalty until they file their income tax returns for the year.

The IRS reported that in recent years the number of taxpayers penalized for underpaying estimated taxes climbed.

It increased 40% between 2010 and 2015. The number of taxpayers filing income tax returns didn’t increase nearly as much.

There are several reasons for the climb in taxpayers being hit with the penalty, but the major one is the wave of Baby Boomers retiring.

Most Americans are used to their employers withholding taxes from their paychecks.

After retiring, they often are surprised to learn about their estimated tax responsibilities and the penalty for not making the payments.

Retirees receive investment income from their taxable accounts: interest, dividends, capital gains, mutual fund distributions and perhaps more.

There’s no tax withholding on these payments.

They also receive IRA and 401(k) distributions and perhaps annuity and pension payments.

Also note that there’s no withholding on these, unless the retiree requests it. The same goes for Social Security benefits.

Retirees need to make estimated tax payments on these and other sources of income, or they will owe penalties.

Fortunately, you can have the penalty abated for the first year of retirement.

A taxpayer who retires or becomes disabled at age 62 or older is eligible to have the estimated tax penalties abated, but only for a year before or after the change.

You have to request the abatement on Form 2210, which is the estimated tax penalty form.

After that transition year, it’s tougher to avoid the penalty.

Taxes have to be prepaid through either withholding or estimated tax payments if you expect to owe more than $1,000 in federal taxes for the year.

Income taxes aren’t the only taxes you have to prepay.

Any other taxes reported on or with Form 1040 are included in the requirement, including the Medicare premium surtax, penalties on IRA distributions or other items and payroll taxes on household employees.

The straightforward way to calculate estimated payments is to project your tax bill for the year, divide the total by four and pay that amount in each installment.

The goals are to avoid the penalty and also either a large payment due or refund with your income tax return for the year.

The penalty is charged from the day the payment was due until the earlier of the date the tax return for the year was due and the date the payment actually was made.

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