- Pay-as-you-go tax system
- Tax law changes affecting estimates
- Underpayment penalties
- Safe harbor estimates
Our tax system is a “pay-as-you-go” system, and if your pre-paid amount is not enough, you become liable for non-deductible interest penalties. To facilitate that concept, the government has provided several means of assisting taxpayers in meeting the “pay-as-you-go” requirement. The primary among these include:
- Payroll withholding for employees;
- Pension withholding for retirees; and
- Estimated tax payments for self-employed individuals and those with other sources of income not covered by withholding.
Determining how much tax to pre-pay through withholding and estimated tax payments has always been difficult, and thanks to Congress’ constant tinkering with the tax laws, ensuring there are no underpayment penalties or tax surprises when the tax return is prepared next year can be challenging.
New tax laws and changes that add complexity to estimating one’s tax liability include: higher ordinary tax rates, higher capital gains tax rates, the phase out of exemptions and itemized deductions for higher income taxpayers, the 3.8% tax on net investment income, and .9% increase in self-employment tax for upper-income self-employed individuals, not to mention a myriad of sun setting tax provisions.
When a taxpayer fails to prepay a safe harbor (minimum) amount, he or she can be subject to the underpayment of estimated tax penalty. This penalty is the short-term federal rate plus 3 percentage points, and the penalty is computed on a quarter-by-quarter basis. So, even if you pre-pay the correct amount for the year, if the amounts are not paid evenly, you could be subject to a penalty. Interestingly enough, withholding amounts are treated as paid ratably throughout the year, so taxpayers who are underpaid in the earlier part of the year can compensate by bumping up their withholding in the later part of the year.
Federal tax law does provide ways to avoid the underpayment penalty. If the underpayment is less than $1,000 (referred to as the de minimis amount), no penalty is assessed. In addition, the law provides two “safe harbor” prepayments. If your state has a state tax, the state’s de minimis amount and safe-harbor percentage and amount may be different.
This underscores the importance of making sure your prepayments are adequate, especially if you have a large increase in income. This is common when there is a large gain from the sale of stocks, sale of property, when large bonuses are paid, or when a taxpayer retires.
If you have questions regarding your pre-payments and 2014 tax planning, or would like to review and adjust your W-4 payroll withholding, W-4P pension withholding, and estimated tax payments to provide the desired tax result for 2014, please give our office a call.