Estimated Taxes for The Ant & The Grasshopper
Every year I see & hear horror stories about estimated tax payment gone wrong. I’m not sure which is worse, the person who didn’t have any idea they needed to make tax payments for both income and self-employment taxes or the person who set aside the money then used it as a down payment on a house, boat or to buy shares in some shady investment scheme.
The problem with estimated payments is not only are they confusing, but the “right” way to make estimated payments depends entirely on your personality and your financial situation.
For instance, if you’re hit with a whopper of a tax bill come April 15th, will you be able to blithely write out a check or will you be in a frozen panic? Does it gall you to get a big refund knowing the US Treasury has had the free use of your money throughout the year? Or is that new sports car irresistible, knowing there’s stash of cash in your savings account, never mind that it’s for your upcoming tax bill?
You’ve probably never considered Aesop’s fable The Ant and the Grasshopper in the context of tax payments before. :) But if you’re a Grasshopper, you’ll probably succumb to the sports car temptation or not have the cash to fork over for a big tax bill in April. But if you’re an Ant, you can probably either write that check if necessary because you either have it anyway or were able to save for it.
So you when you’re deciding how to approach your estimated taxes, first consider if you’re an Ant or a Grasshopper!
Estimated Tax Payments for the Ant
The Ant will want to pay the minimum amount necessary to avoid the underpayment penalty. You may still have a big tax bill at the end of the year, so you may need to put some aside for that too.
The rules for avoiding underpayment penalty are pretty straight forward. If you meet any of the following requirements you won’t be subject to the underpayment penalty.
- The amount due on your tax return is less than $1000.
- You had no tax liability the previous year.
- Your estimated payments were 90% of the current year’s tax liability.
- Your estimated payments were 100% of last year’s tax liability (or 110% if your current year AGI is over $150,000 if married, $75,000 single).
So the easiest way to avoid the penalty is to pay 100% of last year’s tax liability. If you think your AGI will be anywhere close to the $150,000/$75,000 limit, pay 110%. Reduce the prior year’s tax liability by any amounts that will be withheld for federal income tax on your W-2 paycheck, and then pay 25% of that number on April 15th, 17% on June 15th, 25% on September 15th, and 33% on January 15th. Or if you like to keep thing simple, each payment can be 25% of the prior year’s tax liability.
Remember you could still have a large tax liability in April even though you’ve avoided the underpayment penalty.
If you’re prior year’s tax liability was abnormally high you’ll want to meet the 90% requirement. That requires attempting to figure out what your actual tax liability will by for the upcoming year. This is nearly impossible! You’ll never be exactly correct, except by chance. This is what the poor Grasshopper is going to have to attempt so read on…
Estimated Tax Payments for the Grasshopper
If you’re a Grasshopper, then you’re going to want to pay as much of your tax liability through out the year as possible to avoid a big payment come April 15th. You also may not mind a bit of refund, because that will give just you some extra spending money. Am I right? :)
So you’re going to set aside a portion of any income that you make that doesn’t have some withholding for taxes. For instance, if you’re just getting a W-2 paycheck, you shouldn’t worry about that income. But if you’re getting IRA distributions, interest income or alimony that doesn’t have withholdings on it, or if you have income from a sole-proprietorship, partnership, LLC or S-Corp that will end up on your 1040, then you’ll need to set aside something for Uncle Sam.
As a Grasshopper, it might be easier for to send payments to the IRS on a more frequent basis than quarterly. For example, it might make sense for you send payments to the IRS monthly. There’s nothing that says it has to be done quarterly. With EFTPS, you can have payments sent directly from your bank account to the IRS. You can make them as frequently as necessary. It might be an easy thing for you to review your income once a month and then make a payment to the IRS by the 15th of the following month.
But how much to pay? If you expect this year to be pretty much like last year, your total estimated payments should be 100% or 110% of last year’s tax liability. If not, here’s a simplified calculation that I’ve found works well. It’s not exact, but it will probably keep you out of trouble. First, you need to separate your income into three buckets:
- Income that is only subject to ordinary income tax but isn’t subject to tax withholding like
- Interest Income
- Short-term Capital Gains
- S-Corp Business Income
- IRA Distributions
- State Income Tax Refunds
- Non-Qualified Dividends
- Alimony Received
- Subtract: any alimony paid, IRA/Retirement Plan contributions
- Income that is subject to ordinary income and self-employment tax, like
- Sole-Proprietorship Net Income (Schedule C)
- Partnership Net Income
- LLC Net Income
- Income that is subject to long-term capital gains rates, like
- Qualified Dividends
- Long-term Capital Gains
If your annualized income is less than $200,000 married, $100,000 single multiply the total in Bucket #1 by 20%, multiply the total in Bucket #2 by 35% and multiply the total in Bucket #3 by 15%. If your income is over that, then add 5% to the percentage applied to Buckets 1 & 2.
These percentages are estimates but they’re based on experience. These percentages might also be too high if you lots of tax credits. They might be too low if your income is significantly over $350,000.
The 25% on ordinary income will make sure that you’re making the necessary payment if your income is over $200,000 (married) and you caught in 26% flat AMT. There’s an exemption that will keep the actual percentage in the 25% range.
The 35% on self-employment income covers the 20% of ordinary income above plus 15% for self-employment taxes.
The 15% for long-term capital gains & qualified dividend is actually what you’ll owe if you’re in the 25% tax bracket or above.
Keep in mind these are very rough estimates and they’re likely to over estimate your tax. Remember we’re trying to avoid a big payment and a refund will be acceptable. But no matter what you’ll never be able to exactly estimate your actual tax liability unless you have a very fixed income. Remember to use last year’s tax return to help you fine tune the applicable percentages in future years.
Whether you’re an Ant or a Grasshopper, you may be interested in IRS Publication 505, Tax Withholding and Estimated Taxes which goes into the gory details of trying to make a more accurate estimate of your tax liability and goes over the rules and exceptions for making estimated payments.
Remember we have a pay-as-you-go tax system. Pay your taxes on time and keep the IRS happy and out of your life… as much as possible anyway.