Tax underpayment payment and avoidance thereof

In My Humble Opinion
1

Today I was budgeting for the next year or so, mostly making sure that I set aside enough money for big anticipated expenses – holiday travel, refilling the heating oil tank, oh yeah taxes. I bet I’ll end up owing tax this year, says I. So I work out a quick estimate and… shit, I’ll owe something like $1200 dollars.

Basically, I’m a grad student, and I get a taxable stipend. My institution does not withhold any taxes from my stipend. (My wife is also a grad student at a different institution, and for whatever reason, she gets federal tax withheld.) Last year this wasn’t a problem since I had a real job with real withholding for the vast majority of the year.

So I’m trying to figure out what the penalty/interest will be on that tax bill. I see that underpayments less than $1000 are not penalized. I’m having a seriously hard time figuring my penalty from IRS publication 505… I’m not sure which situations apply to me, or even where I can do the calculation.

But as a quick ballpark – would I pay a penalty on $1200, or $200? How much is the penalty/interest in any case? It seems that the penalty won’t be very large in either case, such that it might be easier to just pay it rather than spending my time and money to get professional tax advice. Even a 10% penalty on $1200 is just $120, which is around what I would expect to pay for professional tax help.

And I see that there are estimated payments. I could make a slightly late payment right now for the first three quarters, and then another payment for the fourth quarter… If I pay that now, how much would that reduce my interest & penalty?

(You Are Not Giving Me Professional Tax Advice, I Should Really See A Pro Anyways, etc…)

2

I’m not in any way a tax guy so I’m a bit confused, but why do you have to pay a penalty? if you are talking about the income you are earning this calendar year, don’t you have until April of next year to pay before you get a penalty?

3

I’ve always been under the impression that you can’t start making quarterly payments late in the year. I thought you had to start from the beginning to do that. Some years I pay quarterly, but most years I don’t bother. I just do a rough calculation in October or so, and if I have a big shortfall, I adjust my paycheck withholding to cover it. But the rules for the underpayment penalty aren’t just “is the underpayment over $1k.” There are other factors, like how much you owed the previous year. As a data point, last year I ended up owing an amount well into five figures, and I didn’t have an underpayment penalty at all because I’d withheld substantially more than my tax liability from the previous year.

(Insert standard disclaimer about this not being tax advice. And add to that the fact that I have a professional who does my taxes, so I don’t understand all the intricacies.)

4

Yeah, I’m pretty confused too. But basically, if you owe a lot of taxes (more than $1000), you can’t just write a check to the IRS every April 15. If you don’t have taxes automatically withheld from your income, you’re supposed to make quarterly tax payments. By April 15, that money should have been given over to the IRS months ago – and they’ll charge interest accordingly, with an added penalty.

By now, I should have paid $300 on March 15, June 15, and September 15. I think.

5

Sure you can - what if your tax situation changes late in the year?

Now, you’re supposed to pay it as you go if the tax situation warrants it (e.g. pay 300 each quarter if the money was earned evenly over the course of the year), but I don’t know how strictly they enforce that or what steps they take to verify it. One year, due to something-or-other early in the year, I paid several thousand in early January (to cover 4th quarter of the just-ended tax year) and had no problems. They never came after us for any kind of underpayment penalty. Maybe a huge extra payment late in the year might get their attention.

6

Likewise, IANATG (not a Tax Guy), but I have some experience making estimated payments due to self-employment income. Admittedly, not for any large amounts of income; just relatively penny-ante stuff here.

First of all: The tax law seems to require clairvoyance on the part of the taxpayer, and you can (in theory at least) face penalties for clairvoyance failure. You are not only required to pay taxes as-you-go (on a quarterly, approximately, basis), but you may even be required to pay taxes on income before you earn or otherwise receive that income!

If your income is not subject to withholding, you must make quarterly payments. (Note the due dates carefully though! They are NOT equally spaced out at 3-month intervals!) The rules explicitly state that your annual tax liability must be paid in four EQUAL amounts. Thus, if you will receive a large portion of your income later in the year, enough to significantly raise your tax liability, you must increase ALL FOUR of your quarterly payments equally – even the earlier ones!

This implies that you must know, at the start of the year, that this will happen. This is where the clairvoyance requirement comes in. If you get a large gig later in the year that you had no way of predicting early in the year, then tough shit for you. Technically, you can be dinged a penalty for underpaying your estimated taxes early in the year.

Nevertheless, you CAN adjust your quarterly payments as necessary to pay your current quarter liability AND to make up for any shortfall in your earlier payments. I’ve never heard of the IRS fussing about your payments not really being all equal. At worst, you might have to pay some penalty, at least if there was some significant amount there. The penalty is simply a percentage of the amount you underpaid, for the length of time that it remained underpaid. So if you underpay one quarter and make it up two quarters later, you pay the penalty for a two-quarter period. Typically, not a big deal (unless you’re talking about really big bucks).

If your income is very irregular throughout the year, and you know this in advance, there is another plan called something like the “annualized” estimated payments (or something like that), in which you can make payments each quarter according to your earnings that quarter. But the catch is – or rather, the catches are – you must know and declare this at the start of the year, and fill out some sort of worksheets about it, AND you must know (or estimate) in advance how much you will earn in each quarter. So you STILL need that clairvoyance! I never quite saw the point, since it always seemed to me that you could always adjust your quarterly payments anyway. Again, I suppose the IRS only really fusses when there is big money involved.

7

The IRS would certainly prefer to receive their money quarterly, and you (not the OP, the generic “you”) do indeed become at risk of getting hit with a penalty if you don’t, but if your income truly is uneven for whatever reason, realistically they’re not going to nail you as long as you’re not too blatant. What if you win 10,000 in December? What if you take a big retirement account distribution? Those are all totally unforeseen events.

The OP certainly should have been paying quarterly - or, alternately, should have had his wife adjust her withholdings to cover them both. This was what we did when my husband was working a job that didn’t withhold taxes, and it’s what we did when we had a household employee: adjusted my withholding to cover the whole shebang.

In fact you can still do this: every year about this time I take a look at our withholding for the year to date and make tweaks for that very purpose. So we wind up with more withholding later in the year, and it all evens out (then I have to redo the calculations in the new year or risk being waaaaay overwithheld). If your wife bumps up her withholding 100 dollars or so a pay period, that may reduce your joint liability enough that you’re not at risk of paying a penalty.

Yes, if you get audited, they could look at your quarterly income, say “you shoulda paid earlier” and nail you with a bit of a penalty, but I really wouldn’t sweat it too much.

8

If your calculation is wrong and your tax for 2012 turns out to be $1111 or less, then you will owe no penalty. That’s because 90% of 1111 is $1000.

Otherwise…

Assumptions: Your 2011 AGI was under $150,000. You had no withholding in 2012. You wait until April 15, 2013 to make any payments. The penalty rate for the first quarter of 2013 remains unchanged at 3% per annum.

First calculate the following two amounts:

  1. 90% of the tax you owe for 2012.
  2. 100% of the tax you owed for 2011 (before taking out any withholding or other payments).

Take the lower of the above two numbers and multiply by 2%.
That would be your penalty if you waited all the way to April 15, 2013 to make any payments.

For example, let’s say your 2011 tax (before withholding or payments) was $5000 and your 2012 tax turns out to be $1200.
90% of $1200 is $1080.

The lower of $5000 and $1080 is $1080.
Penalty is 2% x $1080 = $21.60

The penalty is calculated on a daily basis. So that means for every day you beat the April 15, 2013 deadline, your penalty is reduced by a little bit. (The reduction is not linear, since different amounts are outstanding each quarter.)

Assuming your 2012 tax due does turn out to be $1200, calculate what is called your “required quarterly installment” the same way we calculated the amount subject to penalty and divide by 4. In other words, if we used the same example as above (2011 tax was $5000 and 2012 tax is $1200), your required quarterly installment would be $1080/4 = $270.

The due dates for the first three installments have already passed. You can’t reduce the interest that has accumulated to date (except by using the annualized installment method, which I don’t want to get into), but you can prevent any more interest from accumulating on this amount by paying $270 x 3 = $810 now.
To do this, send in Payment Voucher 3 from 2012 Form 1040-ES with a check for $810. (Yeah, it will be a couple of days late, don’t worry about it.) And then send in an additional $270 with payment voucher 4 by January 15, 2013. Send in the remainder of your tax due by April 15, 2013.

Or just say “screw it” and pay the whopping $21.60 penalty when you file your 2012 tax return. The annualized rate is only 3%. That’s probably less than you pay on your credit card. In fact, if you are carrying a credit card balance, you might be better off using that $810 to pay down your balance.

Additional hint: When you file your 2012 tax return, don’t attempt to calculate your penalty yourself. Let the IRS do it for you. In practice, the IRS does not send bills for small amounts, unless there is some other reason to also send you a bill. No one knows exactly what a “small amount” is.

9

Actually, if he underpays, there is no audit required to calculate the amount of the penalty. They have computers. The amount due will be calculated from the data right on his return in a matter of seconds and a bill sent out.

In the case of people who have uneven income or “unforeseen events” there is an exception to the penalty for underpayment of taxes called the “annualized installment method” See Schedule AI on Form 2210. However, if the taxpayer does not attach Form 2210, the penalty will be calculated on the assumption that the annualized installment method does not apply. But most people will not actually need to resort to the annualized installment method to avoid a penalty on an end-of-year windfall since it may be covered under the previous-year-taxes safe harbor.

The reason that the withholding late in the year works for you is because Congress wrote the law to say that it is presumed that the withholding for the entire year was paid in four equal installments. So for example, if you win $10,000 in the lottery in December and $2800 is withheld, that is treated as if $700 was withheld on each of the four quarterly due dates despite the fact that it was actually all withheld at the end of the year. Similarly, the total amount withheld from your wife’s salary during the year is all added up and divided by four to determine her quarterly payments, so having a little extra withheld at the end of the year will make up for not having enough withheld at the beginning of the year.

It should be noted that this same rule does not apply to estimated tax payments that you mail in yourself. Making a big estimated tax payment at the end of the year does not make up for underpayments at the beginning of the year (but it does stop any more interest from accumulating).

10

Actually, not.

There are three methods by which you can calculate your required quarterly installments:

  1. based an 90% of this year’s taxes (requires clairvoyance)
  2. 100% to 110% of last year’s taxes (no clairvoyance required)
  3. the annualized installment method (no clairvoyance, but a lot of calculations required).

You can choose whichever is most favorable to you. Most people just chicken out and use the previous year’s taxes method.

Ignoring the AI method for the moment,
let’s say last year’s taxes were $100 and this year’s taxes turn out to be $1 billion. You would be perfectly OK making quarterly payments of $25.

Correct.

No, you do not have to declare anything at the beginning of the year. You just have to fill out Schedule AI on Form 2210 and file that with your tax return at the end of the year.

And you do not need to estimate your income for the quarter in advance in order to use the AI method. The quarterly installments are paid in arrears. So, for example, you have until April 15 to determine your Annualized Income for the January 1 to March 31 quarter.

The AI method is the exact opposite of clairvoyance. You earn the money each quarter and calculate the taxes on it at the end of the quarter in which you earned it.

Even if you didn’t realize what you were doing and accidentally made sufficient payments to satisfy the requirements of the AI method, you still get to reap the benefits simply by filing Form 2210 at the end of the year.

11

There is a lot of (dare I say it) “ignorance” surrounding the subject of estimated taxes. People have a lot of theories about how they work, but they are unfortunately incomplete. Once you learn the rules, they are actually not that hard.

To anyone who is interested, Kaye Thomas, a tax attorney, has written an informative, non-technical primer on estimated taxes. It is an easy-read aimed at investors, but the same information applies no matter how you earn your money. I would urge anyone interested in the subject to read it:

Fairmark Guide to Estimated Taxes.

12

Please ignore this line.

That was stupid. The actual rule is if your total tax for the year minus withholding (but not estimated payments) is less than $1000, you do not owe a penalty. If you owe $1000 or more, then you ignore the $1000 rule.

13

Whoa, I’m not grokking what you’re saying here.

If I made sufficient payments as described here (“accidentally” or otherwise), what benefit do I get by filing Form 2210 that I would not get otherwise? Do you mean that, absent the From 2210, I might still have to pay a penalty just for having made irregular payments?

I thought for sure that the rules for the Annualized method required me to fill out some detailed worksheets at the start of the year, containing income information about the coming year that might require clairvoyance. But, as I wrote earlier, I deal with penny-ante amounts, and I read all that several years ago, and haven’t thought much about it since.

Basically, I’ve computed my estimated payments by Method #4: Simply make a rough guess (as best I can) about my expected income for the year, then divide by 4, then round to some nice round number that I can do arithmetic with in my head, and that’s what I pay each quarter. Then, as I prepare each subsequent quarterly payment, re-compute things and adjust the payment as needed.

The instructions (and the examples with them) are overly scary because they make it sound like you have to make precise computations, and if you’re a few dollars off, the IRS will seize your home, your car, your husband/wife, your bank account, and your dog, and fine you ten thousand dollars a day ever after. So when I round off my payment amount, I always round UP. I guess there’s actually a reason that estimated payments are called estimated payments.

14

(Missed edit window. Add the following to the above post: )

ETA: Remember, the tax rates you must pay each quarter are still based on the total amount you will make all year, so you still need to know, or guess, that in order to compute the right quarterly payments, even with the Annualized method. I think that was the Clairvoyance Catch that I’m remembering, even with the Annualized method.

15

There is not enough information on your regular return to determine whether you paid enough tax under the Annualized Installment Method. If you don’t file Form 2210, the IRS will compute your penalty under the 90%-of-current-year method and the previous-year’s-tax-method. It will take the lower of the two numbers and send you a bill for that amount (if greater than $0).

The law IRC 6654(d)(2)states that the taxpayer must establish that the calculation under the AI method is lower than the calculation established by either of the above two methods. It allows the Secretary of the Treasury to prescribe regulations by which the taxpayer may do this. The Secretary has prescribed that the election to use the AI method shall be done on Form 2210 where you will show your calculations.

So, yes, you may be entitled to pay a lower penalty amount (or no penalty at all) under the AI method. But if you don’t file Form 2210 and show your calculations, you will not get the benefit of the AI method. There is no other way that the IRS will know how much you should have paid under the AI method and the law requires you to make an affirmative declaration that you wish to use it.

I assure you, it’s not necessary.

The penalty (although it’s technically called a penalty, it is really interest) is based on the federal short term term interest rate (the interest rate at which the government borrows money for a short term) plus three percentage points, rounded to a whole number. It changes every quarter. The federal short term interest rate is a smidge above 0. So right now, the penalty is hardly anything (3%). It was a lot more painful when short-term interest rates were higher.

16

No.

It’s easier to use an example than to explain.

To figure your required payment for the first quarter under the AI method, take your actual income for the first quarter and multiply by 4. Then subtract actual deductible amounts paid in the first quarter and figure your tax on that amount as if that were your income for the whole year. Multiply the tax by 22.5% (which is 90% of 25%) and that is the amount you have to pay at the end of the first quarter. How much you make in any subsequent quarter does not matter. This is all you have to send in.

To figure your installment for the second quarter, take your actual income from January 1 to May 31, annualize the amount, and subtract any deductions during that period. Figure your tax on the annualized amount as if that were your income for the whole year then multiply by 45% and subtract the required payment from the first quarter.

And so on.

In no case does figuring the quarterly installment require you to know any future income amounts.

Please here is Form 2210 for 2011. The AI calculation is done on page 4. Work through an example until you understand it.

17

Thanks for the advice. I’m still not entirely clear how the penalty would be calculated, which would be nice for a “just suck it up and pay” vs “get professional advice NOW!” decision.

I’m definitely paying much less than 90% of last year’s taxes. In 2011 my wife and I both had Real Jobs, so this year my total tax bill is around 50% of what we paid last year.

I guess we’ll just do some significant extra withholding through my wife’s paycheck. I wish my institution did any kind of withholding… the only advice they give me is “you might have to figure out how to pay taxes yourself. LALALA NOT OUR PROBLEM!”

18

You didn’t mention that you had a wife or that she had a job.

If you intend to file a joint return, you have to look at the total tax owed and paid by both spouses, not just your own.

Assuming you file a joint return, if your wife has enough withheld by the end of the year to cover 90% of the joint tax that the two of you combined will owe for the entire year, no need to worry about any penalties. For example, if the total tax shown on your joint return is $10,000 and she has $9000 withheld, there will be no penalty of any kind. And it doesn’t matter if she has it withheld at the beginning of the year or the end of the year.

If you want to clarify for yourself how the penalty is figured, fill out Form 2210. The 2012 Form 2210 is not yet available, but use the 2011 one and bump up the dates by one year. The penalty rate in 2011 was a little bit higher than the 2012 penalty rate, so using the 2011 form will give you a slightly higher penalty than what you actually would owe (if anything).
The maximum conceivable, worst-case penalty on a $1200 underpayment would be $21.60. That wouldn’t even pay for one hour of consultation with a professional. That’s a WORST CASE assumption. In all likelihood it would be less and could even be nothing.

19

Sorry. Too late to edit previous answer.

Take what your total 2012 federal income tax will be.
Multiply by 0.9.
Subtract your wife’s total withholding for the year.

If the number is 0 or negative, no penalty.
If the number is positive, multiply by 2% to calculate penalty.

This assumes you make no tax payments other than your wife’s withholding.
It also assumes that your wife’s withholding will be less than 100% of your 2011 income tax.