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3 Ways Taxpayers Can Sidestep Possible Estimated Tax Penalties

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Dec 24th 2014
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Everyone with a regular paycheck knows that you pay your federal income taxes “as you go” through table-based withholding payments. Problems can crop up, however, for those who get some or all of their income from other sources. Freelancers, landlords, and retired investors receive income not subject to income tax withholding and can be liable for an “estimated tax penalty.” Now is the time for accountants to set up such nonwithholding clients so they pay the right amount throughout the year.

Common income streams not typically subject to withholding include:

  • Earnings from a business
  • Interest income
  • Dividends
  • Capital gains from sales of stock or other assets
  • Alimony

For taxpayers in these and related situations, the US government requires you to make quarterly installment payments of tax during the year on April 15, June 15, Sept. 15, and Jan. 15 of the following tax year. (The due date is moved to the following business day if it falls on a weekend or holiday.) Thus, the next quarterly due date for 2014 coming up is Jan. 15, 2015.

No penalty is imposed if your tax liability is less than $1,000. Otherwise, the penalty is the same as the interest rate announced quarterly for other tax underpayments.

But not to worry. The estimated tax penalty can easily be avoided if you qualify under any one of these three safe-harbor rules:

  1. Pay at least 90 percent of the current year’s tax liability. This requires a calculated "guesstimate" of your current tax situation.
  2. Pay at least 100 percent of the prior year’s tax liability or 110 percent if your adjusted gross income (AGI) for the prior year exceeded $150,000. This is often the easiest method to use because you know the exact amount of your previous tax liability.
  3. Pay at least 90 percent of the current year’s annualized income. The annualization method may work for certain individuals, such as independent contractors, who receive most of their income on a seasonal basis.

These safe-harbor rules provide taxpayers with flexibility. What’s more, Uncle Sam isn’t fussy how you pay the taxes as long as you pay on time. In other words, you can meet your federal income tax obligations through withholding, quarterly installments, or any combination.

Year-end strategy: Taxpayers who have tax withheld from their paychecks might want to increase their tax payments as the year draws to a close. For instance, you may earn more salary than the threshold for the Social Security wage base ($117,000 in 2014). After you cross the threshold, you can allocate the payroll tax savings toward extra withholding payments. This enables you to fulfill your tax obligations without reducing your take-home pay for 2014.

Related article:

The Strange and Subtle Rules of Estimated Taxes

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