Strategies for Avoiding Underpayment Penalties for Estimated Tax

This post provides strategies for avoiding underpayment penalties for estimated tax including increasing withholding and IRA distributing. The post also explains the method that yields the smallest required payment for each quarter.

Estimated Tax Rules

Taxpayers have to pay the federal income tax throughout the year either through withholding in W2 or/and estimated tax.  People who are an employee and have multiple sources of income such as stocks, pensions, commission, bonuses, etc. may need to pay tax through both withholding and estimated tax payments. The main point is IRS wants to collect taxes on the go quarterly rather than at once by April of the following year.  On the other hand, if a taxpayer gets a refund from IRS, he/she may also get an interest on the late refund as well.  Therefore, taxpayers are required to make quarterly estimated tax payments, else underpayments will result penalties.  However, underpayment penalties for estimated tax are avoided if taxpayers satisfy one of the following conditions

Small tax liability due

If the tax balance due after federal income tax withholding or estimated tax payments is less than $1,000, no penalties are assessed.

No tax liability for the prior year

A taxpayer can avoid the underpayment penalty if  he/she has no tax liability for the prior tax year. In order to qualify for this condition, the taxpayer was a U.S citizen or resident for the entire year. The taxpayer if required must file the prior-year return for the whole 12-month tax year showing tax liability

Estimated tax payments

Generally,  if the combination of withholding and estimated tax at least 90% of the tax for the current year or 100% (for those with income less than $75,000 or $150,000 for married couples) or 110% (for those with income higher than $75,000 or $150,000 for married couples) of the tax shown on the return for the prior year, whichever is smaller.

Payment	Income Earned Period
1st Payment	January 1 to March 31
2nd Payment	April 1 to May 31
3rd Payment	June 1 to August 31
4th Payment	September 1 to December 31

The payment due date is usually 15 days after the income earned period.  For example, the 1st payment deadline which income earned period from 01/01 to 03/31 is April 15th.   Specific deadlines vary from year to year.  Please check IRS website for payment due dates

To pay for estimated tax online, taxpayers can open an account with IRS and pay via  https://www.irs.gov/payments

Taxpayer should minimize the estimated tax payments to the amount no greater than required to avoid underpayment penalties.   There are 3 accepted methods of estimated tax payments.  IRS doesn’t require taxpayers to use the same method for each quarter.  Therefore, taxpayers can use whatever methods that yield the minimum required payments each quarter.

100% or 110% prior-year tax

The combination of the tax paid through withholding or/and through estimated payments equal 100% of the prior-year tax for individuals having income less than $75,000 or married couples having income less than $75,000.  However, this combination is increased to 110% for individuals who make more than $75,000 or married couples who make more than $150,000.

90% of current year tax

The tax paid through withholding or/and through estimated tax payments equal 90% of the current-year tax.

Example 1: A & B, a married couple on 20X1 tax return, has AGI (adjusted gross income) in 20X1 is $250,000,  the federal tax is $47,897 (19.16% marginal tax rate).  In 20X2, the couple expects an income of $350,000.   A & B source of income is from W2.  

Since the A&B couple’s income is $250,000 which is higher than $150,000 for married couple, then 110% of the prior-year tax is used for the estimate tax payment.  The estimated tax for 20X2 would $52,687 ($47,897 x 110%).  Quarterly payments would be $13,172 ($52,687/4)

In 20X2, $350,000 income for married couple would most likely result a marginal tax rate at 23.48% or $82,184. If the taxpayers use 90% of current year tax, the estimated tax payment for 20X2 would be  $73,966 ($82,184 x 90%) .  Quarterly payments would be $18,491 ($73,966 /4)

Using 110% of prior-year tax would result a lower estimated payment ($52,687) than that of using 90% of current year tax (at least $82,184, for simplicity the calculation ignore additional Additional Medicare Tax).

Annualization method

Annualization method allows taxpayers to annualize income and estimate the amount of tax payments depending on actual year-to-date income for each quarter of the year.  This method is ideal for those who have unstable flows of income such as bonus, stocks, commission, real estate sale, or people who don’t control over when the income is received. 

Taxpayers pay through withholding and/or timely estimates an amount equal to 90% of the current-year tax computed based on annualization of actual year-to-date income for each quarter of the year.

Step 1: Estimated Taxable Income = (actual income for all the months prior quarterly payment due x 12)/(number of months that represent the income) (1)

Step 2: Calculate Income Tax based on the Estimated Taxable Income from (1)

Step 3: Estimated Tax Payment = 90% x Income Tax 

Examples 2: 

Similar to example 1, A & B, a married couple on 20X1 tax return, has AGI (adjusted gross income) in 20X1 is $250,000,  the federal tax is $47,897 (19.16% marginal tax rate). In 20X2, A & B anticipate that their income will be much less than 20X1 as A quits her job to open her own company, and the new company won’t generate much income.  However, In November, A & B realized a $100,000 short-term capital gain from selling their short-term stocks.  The income break-down is as below

 January 1 to March 31: $48,000

 April 1 to May 31:          $37,000

 June 1 to August 31:     $56,000

September 1 to December 31: $67,000 + $100,000 short-term gain from stocks

Following the above formula to figure out the estimated tax payment using Annualization method                              

1st Payment	January 1 to March 31
Estimated Taxable Income	$48,000 x 12 months/ 3 months = $192,000
Estimated Tax After Standard Deduction ($24,000)	$31,657 (16.49% marginal tax rate)
1st quarter estimate payment	$31,657 x 90% /4 = $7,123

2nd Payment	April 1 to May 31
Estimated Taxable Income	($48,000 +37,000) x 12 months/ 5 months = $204,000
Estimated Tax After Standard Deduction ($24,000)	$35,017 (17.16 % marginal tax rate)
Estimate Tax per quarter	$35,017 x 90% /4 = $7,879
2nd quarter estimate payment	$7,879 x 2 – $7,123= $8,635(payments for 2 quarters – amount paid for the 1st quarter)

3rd Payment	June 1 to August 31
Estimated Taxable Income	($48,000 +$37,000 + $56,000) x 12 months/ 8 months = $211,500
Estimated Tax After Standard Deduction ($24,000)	$37,117 (17.55 % marginal tax rate)
Estimate Tax per quarter	$37,117 x 90% /4 = $8,351
3rd quarter estimate payment	$8,351 x 3 – ($7,123+ $8,635) = $9,295(payments for 3 quarters – amount paid for the 1st and 2nd  quarters)

4th Payment	September 1 to December 31
Estimated Taxable Income	($48,000 +$37,000 + $56,000 + $167,000)  = $308,000
Estimated Tax After Standard Deduction ($24,000)	$66,786 (21.68 % marginal tax rate)
4th quarter estimate payment	$66,786 x 90%  – ($7,123+ $8,635+$9,295) = $35,054(payments for 4 quarters – amount paid for the 1st, 2nd  and 3rd quarters)

Please note that the calculation doesn’t account for self-employment tax and additional Medicare taxes

Choosing the right methods for minimizing estimated tax payments

Taxpayers should minimize the required estimated tax payments to maximize the cash flow and to avoid underpayment penalties .  Taxpayers can choose the same estimated tax method throughout the tax year.  In addition, taxpayers can also choose different estimated tax methods which can produce the smallest required  payment for each quarter.

Let’s use the example 2 above to compare different results for prior-year tax, current-year tax, annualization methods and combination of different methods for each quarter.  

Period	100% or 110% prior-year tax	90% current-year tax	Annualization Method	Combination methods to yield the smallest required payments
1st Payment	110% x $45,629/4 = $12,548	90% x $66,786/4 =  $15,027	$7,123	$7,123
2nd Payment	$12,548	$15,027	$8,635	$8,635
3rd Payment	$12,548	$15,027	$9,295	$9,295
4th Payment	$12,548	$15,027	$35,054	$12,548
20X2 estimated payments	$50,192	$60,108	$60,107	$37,601

             As a result, if the taxpayers use the annualization method for 1st, 2nd and 3rd quarters and use 100% or 110% prior-year tax method (110% is required in this example because the AGI is greater than $150,000), the total 20X2 estimated payments are smallest ($37,601) compared to other three standard methods. 

Year-end strategies to avoid penalties for estimated tax

By December, what if taxpayers discover that they are most likely to get penalties for underpayments, there are different strategies which can avoid the penalties for underpaid estimated tax at the end of the year.  

• Increase withholding at the end of the year.

  • The strategy is for individuals who has W2 withholding.  Income taxes withheld from wages are considered to spread out evenly throughout the tax year if taxpayers don’t specify exact dates for amounts to be withheld.  Therefore, additional withheld tax at year end is still deemed to spread out throughout the year.  Taxpayers can increase withholding at year end such as 100% withholding on year-end bonus, commission to avoid the underpaid penalties for estimated tax.
    • Example: Taxpayer A who discovers at the end of the year that he is $10,000 underpaid payment, he can increase $10,000 withheld tax through wages or bonus, commission.  The withheld amount is deemed to spread throughout the year which is $2,500/quarter. 

• Use actual dates for tax withheld 

   The  strategy helps taxpayers who have an unstable income flow.  If a taxpayer sells his/her stock and has a large capital gain, use actual dates for tax withheld to avoid underpayment penalties for a specific quarter when the actual income occurs 

• IRA distribution:

  • If a taxpayer owns traditional IRA accounts, this strategy can be used to reduce penalties.  Taxpayers can distribute their IRA and choose to withhold 100% of the distribution for federal income tax purpose.  If the taxpayer can redeposit the withdrawn IRA within the 60-day tax-free rollover period, she/he can avoid underpaid penalties.  The withheld tax is spread evenly throughout the tax year with an equal amount paid on each estimated tax installment due date.
    • Example:  Taxpayer A who discovers at the end of the year that he is $10,000 underpaid payment, he can distribute a $10,000 from IRA with 100% tax withholding.  In another word, A chooses to withhold $10,000 tax.  The withheld amount is deemed to spread throughout the year which is $2,500/quarter. As long as A redeposits $10,000 back to the same account within 60-day period, there’s no tax nor 10% early withdrawal penalty to be assessed on the transaction.  

Minimize Underpayment penalties during filling tax return

Most tax software assumes that taxpayers had the income throughout the year and calculates underpaid estimated tax. This calculation may cause large penalties.  For those taxpayers who have fluctuated in income or have large amount of income in a particular quarter should file the tax form 2210.   Form 2210 shows particular estimated tax payment based on specific income during specific time of the year.  It will allow Schedule AI to select the smaller required payments of the annualized income method or the regular method which leads to lower penalties.

For Turbotax software,  here is the instruction how to add Form 2210

References

“Topic No. 306 Penalty for Underpayment of Estimated Tax | Internal Revenue Service.”, www.irs.gov/taxtopics/tc306. Accessed 15 Oct. 2020.