Have you ever looked at your 1040 U.S. individual income tax return and noticed near the space for your signature there is a space for “estimated tax penalty”?
If you ask your certified public accountant (CPA) what that amount represents, the reply will be you didn’t pay enough in taxes. Your immediate answer may be, “Yes, I did!” and you even may have received a refund.
WHO SHOULD PAY
However, per IRS rules, it’s not just enough to pay your taxes for the year. You need to pay your taxes at prescribed time intervals. Essentially, the year is divided into four payment periods, or due dates, for estimated tax purposes. Those dates generally are April 15, June 15, Sept. 15 and Jan. 15. In general, you must pay federal estimated taxes in 2023 if:
- You expect to owe at least $1,000 in tax after subtracting your tax withholding (if you have any) and tax credits, or
- You expect your withholding and credits to be less than 90 percent of your 2023 taxes (the annualized method) or 100 percent of the tax on your 2022 return. If your 2022 adjusted gross income was more than $150,000 ($75,000, if married filing separately), substitute 110 percent for the 100 percent requirement (the general method).
If you have income from sources such as self-employment; interest; dividends; alimony; rent; and gains from the sales of assets, prizes or awards then you may have to pay estimated tax. This is because while these items generally are not subject to withholding, they are subject to tax.
If you also receive salaries and wages, you may be able to avoid having to make estimated tax payments on your other income by taking more tax out of your paycheck. To do this, file a new Form W-4 (employee’s withholding allowance certificate) with your payroll processing team. Keep in mind that the IRS considers withholding — from your paycheck or others such as pensions, etc. — paid ratably throughout the year. Therefore, if you have the flexibility, you can have extra amounts withheld near the end of the year to “catch up” if you haven’t paid in enough by then.
MORE POINTS TO CONSIDER
- To figure your estimated tax, include your expected gross income, taxable income, taxes, deductions and credits for the year. You can use the worksheet in Form 1040-ES.
- Consider having your CPA prepare tax projections using several income scenarios, and have them updated as the year progresses.
- The disadvantage to utilizing the annualized method as opposed to the general method is that the calculation of your estimated tax payments may be more complex and time-consuming. Additionally, your estimated tax payments must be recalculated at the end of every quarter. If you make an estimated tax payment using the annualized income method for a quarter, you may change to the regular method for a subsequent quarter, but you must recapture the difference between the annualized income installments and the regular installments by adding the amount of the differential for all previous periods to the regular installment for the next payment period.
- An underpayment penalty is imposed on each underpayment for the number of days it remains unpaid. A penalty may be applied if you did not pay enough estimated tax for the year, or you did not make the payments on time or in the required amount. A penalty may even apply if you have an overpayment on your tax return. The penalty is essentially an interest calculation that is currently imposed at a comparatively low rate. It’s not necessarily the worst outcome.
When preparing your 2022 tax returns, many CPAs will include 2023 estimated tax vouchers with their clients’ 2022 tax returns. When there is a material balance due on 2022 returns, vouchers are prepared using the safe-harbor estimate under the general method to avoid 2023 underpayment penalties. Check with your CPA to ensure he or she has considered the underpayment penalty when conducting your tax planning.
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