Avoiding The Estimated Tax Trap

Estimated tax payments are a traditional trap for retirees. Most retirees were employees during their careers and had income taxes withheld from their paychecks. They never had to deal with the estimated tax rules and are surprised by the process in retirement.

If you expect to owe more than $1,000 in federal taxes that will not be 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, Sept. 15, and the following Jan. 15. (If a deadline is a weekend or holiday, it is extended to the next business day.)

Income taxes aren’t the only taxes you have to prepay. If you owe the Medicare premium surtax, penalties on IRA distributions or other items, payroll taxes on household employees, or other items that are reported on or with Form 1040, you need to include them in estimated tax payments.

The IRS assumes income is earned evenly during the year, so the quarterly payments must be equal, though there are exceptions.

States with income taxes also have similar estimated tax payment requirements.

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

The goal is to avoid penalties. The penalty for late or low estimated tax payments is in- terest compounded daily at a rate announced by the IRS each month. The interest rate changes with treasury debt rates. Interest 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.

So it is best to focus on the safe harbors for avoiding penalties and be sure to qualify for one. There are three safe harbors that avoid penalties:

• Pay at least 90% of the current year’s

tax liability through timely estimated tax payments;

• Pay at least 100% of last year’s total tax bill

through timely estimated tax payments; or

• If you are a “high income taxpayer,” pay at least 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 ad- justed gross income on last year’s tax return was over $150,000 ($75,000 for married individuals filing separately). The other two safe harbors do not apply to the high income taxpayer.

The safe harbor rules generally assume that income is predictable and tends to rise each year or will not decline by a significant amount.

When income isn’t earned steadily during the year and you want each estimated tax payment to match income for that three months, consider the more complicated “annualization method.”

Under the annualization method, you compute estimated taxes separately for each quarter. Th s can be tricky because you do not want to pay taxes on gross income. You want to estimate the taxable income for the period, which means apportioning exemp- tions, deductions, losses and other write off to each quarter.

When filing your income tax return, IRS Form 2210 is used to show you do not owe a penalty for underpaying estimated taxes. It also can be used to estimate your payments

for the year under the annualization method. Go to page four of the form and use the table to compute estimated taxes for each quarter. You will need that information anyway when you file the return to show you qualify for the annualization method. After estimating income taxes for the quarter, pay at least 90% of that amount.

The annualization method also is helpful to taxpayers who had a surprising and substantial increase in income late in the year. The sale of an asset or unexpectedly large mutual fund distributions can increase income enough to make estimated payments inaccurate and subject to a penalty unless the annualization method is used.

Remember, the IRS expects you to pay the taxes equally throughout the year unless you use Form 2210 and the annualization method.

There is another way retirees might be able to avoid the hassle and uncertainty of esti- mated tax payments and still avoid penalties.

When taxes are withheld from any payments to you, the IRS assumes the taxes were withheld equally throughout the year, even if they weren’t. Employees can avoid underpayment of estimated tax penalties by having employers increase their tax withholding late in the year.

The rule applies to withholding from any type of taxable income payment. You can have taxes withheld from your annuities, IRA distributions, or other payments you receive. If estimated tax payments for the year are low or you want to avoid quarterly payments, have enough money withheld for income taxes on payments received late in the year. Some people wait until near year end to take their IRA RMDs and have a large part of them withheld for income taxes.

Before deciding to execute this strategy, check with the payer. Some IRA custodians and others place restrictions on how much they will withhold, such as with- holding a maximum percentage from each IRA distribution or withholding only from regular, scheduled distributions. Others require a minimum notice period to change withholding.

There are several ways to make estimated tax payments. The easiest way is to use one of the online options at www.irs.gov/payments.

More details about computing estimated tax payments and avoiding penalties are available in IRS Publication 505, available free on the IRS web site at www.irs.gov.