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Avoiding Estimated Tax PenaltiesFederal
tax law requires the payment of income taxes throughout the year as you
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earn your income. This obligation may be met through withholding or quarterly estimated
tax payments or both. For 1998, if total tax minus withholding and payments is less than
$1,000, you will not be assessed a penalty for underpayment of estimated tax. However, if
you overpay your estimated taxes, you are in effect making an interest-free loan to the
government, which you would probably prefer to avoid. The penalty for underpayment is
calculated as interest on the underpaid balance until it is paid, or until April 15, 1999,
whichever is earlier. The interest rate on underpayments in 1998 is 8 percent (as of
September 30, 1998), and the rates for 1999 will be announced quarterly by the IRS. The
rates are adjusted under a prescribed formula in response to changes in federal short-term
interest rates.
- Methods for Avoiding Estimated Tax Penalties for 1998 Taxes. There are several
ways to avoid estimated tax penalties. The basic rule is to pay the required amount by the
end of the year through withholding and quarterly estimated payments. The required amount
will be one of the following, depending on the individual taxpayer’s situation:
- 90 percent of the current year’s tax liability.
- 100 percent of the prior year’s tax liability (regardless of adjusted gross income
amount).
- 90 percent of the tax liability based on a quarterly annualization of current
year-to-date income.
Penalties are based on the difference between the lowest amount required to be paid by
each quarterly payment date and the amount actually paid by that date. If payments are
based on one of the first two alternatives above, the annual required amount must be
divided equally among the four quarters to determine the cumulative amount due at each
quarterly payment date. In the case of annualized income, however, the amount due by each
payment date is determined based on income to date. Thus, the annualization method may be
the one for you to use if you accrue or receive much of your income during the latter part
of the year, because the annualization method allows for lower required payments in the
early quarters. Table 2-2 illustrates the amount required to be
paid (cumulatively) for 1998 taxes under each method by each date.
Table
2-2
Cumulative Amount of Estimated Taxes to Be Paid |
|
Due Date |
| 1997 Tax Payment
Methods |
15
April |
15
June |
15
Sept |
15
Jan |
| Current
year's tax |
22.5% |
45% |
67.5% |
90% |
| Prior year's
tax (safe harbor): |
25% |
50%
|
75% |
100% |
Tax on annualized
income
to date |
22.5%
|
45% |
67.5% |
90%
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Payments made through withholding from your paycheck (or from your pension or other
payments) are given special treatment. The IRS treats income tax that is withheld as
having been paid equally throughout the year (unless you prefer to use actual payment
dates). This lets you make up for underpaid amounts retroactively, because amounts
withheld late in the year may be used to increase the amounts deemed paid in earlier
quarters.
Thus, you may reduce or avoid underpayment penalties by adjusting withholding late in the
year, something you cannot do with quarterly estimated tax payments. If you find that your
payments to date are inadequate, you should arrange with your employer or pension provider
to adjust your withholdings to the extent possible to cover any anticipated shortfall. The
additional amount must be withheld before December 31 to apply to the current year’s
tax. If you cannot adjust withholding, you should at least make a prompt quarterly
payment, which will stop the growth of underpayment penalties.
- State and Local Rules. Most of the state and local taxing districts have similar
rules and penalties related to the prepayment of income taxes during the year. Since many
states have prepayment rules that vary from the federal requirements listed above, you
need to become familiar with the rules for the states and localities in which you file
returns, and take the steps necessary to avoid underpayment interest and penalties. You
must therefore judge the adequacy of the tax payments to authorities at all levels.
- Other Taxes. When computing your required estimated tax payments, do not overlook
the increasing number of "other taxes" that apply in addition to the regular
income tax. Some, such as the self-employment tax and the alternative minimum tax, have
existed for many years. Others, such as the employment taxes for domestic employees, are
relatively new. For 1998 and thereafter, employers must include FICA taxes for domestic
employees in calculations of their own estimated tax liabilities.
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Tax Guide
