Estimated Taxes are Different This Year

The year’s first required estimated tax payment is coming due, and many retirees should re-evaluate how they compute their payments this year.

Estimated tax payments are a traditional trap for many retirees. Most 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.

Income taxes must be paid through the year as income is earned. If you expect to owe more than $1,000 in federal income 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 September 15 and the following January 15. (If the deadline falls on a weekend or holiday, it is extended to the next business day.)

The IRS assumes income is earned equally throughout the year, so the quarterly payments must be equal, though there are two important exceptions we will discuss shortly.

The penalty for late or low payments is interest com-pounded 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 reported on Form 1040: income, self-employment, and any others on the form. The straightforward way to make estimated payments is to project your tax bill for the year, divide the total by four, and pay that amount each quarter.

The first goal is to avoid any penalties, but estimating taxes for the year is difficult. 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 this year; 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 adjusted 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.

States with income taxes also have estimated tax requirements. The due dates usually are the same or similar to those for federal taxes, but the formulas for avoiding underpayments vary.

Most retirees choose one of the safe harbor methods. Those safe harbor methods, however, might not be very efficient in this year’s economic environment.

Often a large portion of retirees’ income is not fixed. Interest and dividends on investments fluctuate during the year. There might or might not be capital gains. There even could be capital losses. For the many retirees who invest in mutual funds, distributions cannot be forecast. Many learned in 2008 that a fund can have a negative return for the year and still have a large taxable distribution.

Another complication for 2009 is that required minimum distributions do not have to be taken from IRAs and other qualified retirement plans. If you decide not to take RMDs in 2009 and base your estimated taxes on 2008’s bill, you might overpay estimated taxes.

The safe harbor rules generally assume that income rises each year or will not decline by a significant amount.

A more complicated way to determine the estimated tax payment but one that will make the payments more accurate is the “annualization method.”

Under the annualization method, you estimate the taxes due for the income earned each quarter. You compute estimated taxes separately for each quarter. This 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 exemptions, deductions, losses, and other write offs to each quarter. That is not as difficult as it might sound. You estimate their totals for the year and divide by four.

IRS Form 2210 is used to show you do not owe a penalty for underpaying estimated taxes. It can be used to estimate your payments for the year. 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 without the annualization method.

Unless you use the annualization method, 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.

There is another way retirees might be able to avoid the hassle and uncertainty of estimated 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 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.

For example, when asking an IRA distribution, you can instruct the IRA custodian to withhold enough to cover all your income tax obligations for the year if the distribution is large enough. 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.

Before executing this strategy, check with the payor. Some IRA custodians and others place restrictions on how much they will withhold, such as withholding a maximum percentage from each IRA distribution or withholding only from regular, scheduled distributions. RW March 2009.