Written by: Elissa Wurf, PhD, CPA, EA
Today I made my weekly trip to the grocery store. When I returned home and put my groceries away, I noticed that my receipt came with a warning: the broccoli florets I purchased had a recall for Listeria contamination, and I was instructed to return them to the store for a refund.
While I was a little annoyed with myself for not checking the receipt before leaving the store, I was more annoyed with the grocery store for this method of handling the problem. Why didn’t the store just remove the product from the shelf?
It is in the spirit of avoiding a similar “too little, too late” annoyance that I want to discuss the question of tax withholding and estimated payments.
Forms of Income and How Taxes are Paid
The United States operates on what the IRS refers to as a “simplified Pay-As-You-Earn (PAYE)” system (sometimes referred to as “Pay as You Go”). What this means is you should pay income taxes as the income is earned, and not just when the tax return is filed the following year.
Anyone who earns a paycheck is familiar with this. Your gross income for every pay period is reduced by federal, state, Social Security, Medicare, and other statutory taxes, as well as by deductions for retirement plan contributions and insurance benefits to yield your take-home pay.
But for many other forms of income, there is either no withholding or optional withholding. These other forms of income include interest, dividends, capital gains, alimony, IRA draws and other retirement income (Social Security benefits, pensions, annuities, and qualified plan withdrawals), rental income, estate and trust distributions, and business income from self-employment or ownership of a partnership or corporation.
For taxpayers who do not have much income from these other sources, the withholding from their paycheck, coupled with the itemized or standard deduction on their tax return will probably yield a refund come next April.
But taxpayers who have significant income from one or more of these other sources have a choice to make if they wish to avoid a possible underpayment penalty and a big tax bill next April.
Withholding versus Estimated Tax Payments for Retirement Income
Retirees can choose to make advance tax payments using estimated payment vouchers, which a tax preparer typically provides for the following year along with the return. But withholding is also an option available for most types of retirement income, and it is certainly the better way to go.
One of the biggest advantages is that withheld payments are treated by the IRS as having been received ratably throughout the year. Even if, for example, you have withholding taken on an IRA withdrawal on December 31st (not that your Financial Strategist would ever suggest waiting that long!), the tax is allocated evenly across all twelve months. This treatment of the payment minimizes any possible penalties and interest.
Also, when you take withholding on a retirement payment, you don’t need to worry about remembering the deadline or paying postage: You just set the payment once and then can forget about it unless circumstances change.
If your tax situation is fairly consistent, a retiree can use form W-4V (line 6) to set withholding on their Social Security benefits at their marginal tax bracket. People receiving a pension or annuity income can contact the provider of this income to complete a Form W-4P for withholding from those forms of income as well.
Those taking IRA distributions can contact their Financial Strategist and ask for advice on a suggested withholding rate. In that case, your Financial Planning Analyst will run a tax projection to confirm the suggested amount.
If you have large capital gains during a year, it is particularly important to update the projection to avoid underpayment.
However, if you are over the age of 70½ and making a Qualified Charitable Donation (QCD) from part of your IRA Required Minimum Distribution (RMD), you would not withhold taxes on that, as that distribution is tax-exempt.
Estimated Payments are still the Vehicle of Choice for Self-Employment Income
In contrast to retirement income, those earning self-employment income still need to pay the quarterly estimated payments. The hassles of needing to remember to make the payments and the small expense of postage can be avoided by setting up a Direct Pay account with the IRS (and a similar one with your state tax agency). This allows you to pre-schedule all payments for the year, using the traditional method of paying taxes quarterly on one-fourth of your projected annual income.
There is an advantage of making estimated payments by voucher for those earning business income that is variable throughout the year. Namely, you can adjust the tax payment to correspond to the income earned just during the period. Using the annualized income installment method, your tax preparer can establish an annualized schedule to avoid any potential underpayment penalties that might arise from paying taxes on variable income using the traditional method. Making estimated payments by voucher also removes the need to come up with the funds for a large tax payment during a period when little or no income has been earned.
Safe Harbors: The Bottom Line
Both the IRS and states provide “safe harbors” for determining how much tax needs to be paid by January 15th of the year that the return is timely filed to limit interest and penalties. Either 90% of the current year’s tax or 100% (110% if AGI is over $150,000) of the prior year’s tax needs to be in to the IRS by the fourth quarter’s payment deadline of January 15. Many (but not all) states have 100% as the prior year safe harbor.
A general rule of thumb is that, if your income is going up (your wages have increased, you have big capital gains, or you started a new income stream, like taking Social Security or starting RMDs), you are better served by relying on the Prior Year Safe Harbor. However, if you are certain that the current year’s income will be less than the prior year’s income (for example, if you sold a business last year or took a lump sum distribution), then the Current Year Safe Harbor will suffice.
And, as always, please contact your financial planning team with any questions you might have. Not a client yet? Submit our questionnaire to see how Agili can help you with the issues presented in this blog (and many others!).