MLR

How to avoid underpayment penalties

Categories:

U.S. income tax is basically pay as you go. As you earn income during the year, you’re expected to pay your taxes on it – or you’ll be penalized.

You may pay taxes in basically two ways:

  • Through withholding from your paycheck
  • By making estimated payments if your withheld tax is insufficient

Those needing to make estimated payments are self-employed individuals who run their own businesses or professionals in business for themselves, as well as investors and retirees who receive interest or gains, among others.

For 2014, estimated tax deadlines for individuals are April 15, June 15 and Sept. 15, 2014, and Jan. 15, 2015. The January payment may be skipped without penalty if you file your 2014 tax return and pay all taxes due by Feb. 2, 2015.

If you do not pay enough tax throughout the year, penalties may apply. But with proper planning, the penalties are avoidable.

You won’t be penalized if you owe less than $1,000 in taxes after subtracting withholding and credits. You also won’t be penalized if you pay at least 90 percent of the tax you owe for the current year, or 100 percent of the tax shown on your tax return from the prior year.

If adjusted gross income for 2013 was more than $150,000 for married taxpayers, 110 percent of the 2013 tax liability must be paid for 2014, or there will be a penalty.

There are special rules for farmers and fishermen. If two-thirds of income comes from farming or fishing, only 66 2/3 percent of the current-year tax owed is payable in one installment due Jan. 15.

In general, your estimated tax payments should be made in four equal amounts to avoid a penalty. But if your income is received unevenly during the year, annualizing your payments and making unequal payments may enable you to eliminate or lower your penalty.

If it appears that you will be subject to an underpayment penalty, you may be able to reduce or eliminate the penalty by initiating or increasing your quarterly estimated tax payments or by adjusting your withholdings.

A quirk in the penalty rules treats withheld taxes – even those withheld late in the year – as if they had been taken evenly throughout the year. So, if you’re employed, instructing your employer to withhold more from your pay can even eliminate penalties that accrued earlier in the year.

While most people want to avoid unnecessary penalties, it is seldom a good idea to pay more than the law requires or to pay your taxes earlier than necessary. Why let the government hold your money only to return it to you next year as a tax refund – with no interest?

Your goal should be to pay just enough to avoid an underpayment penalty but not so much as to create a large refund. Consult with your tax adviser to optimize your tax payments to avoid penalties.