Individual Taxes: Withholding, Estimated Payments, and Underpayment of Estimated Tax Penalty

Individuals who owe tax with their Form 1040 or extension might owe more than they expected. The federal income tax is a pay-as-you-go tax. If you wait until you file your return to pay your tax, penalties may apply. There are two ways to pay as you go: withholding, and quarterly estimated tax payments.

Withholding

Federal income tax is withheld from the paychecks of most employees. The amount withheld from each pay is determined by the amount of pay, and the entries you made on the Form W-4 which you provided to your employer.

Tip: Many employees fill out a W-4 when they begin a new job and never change it. Although it’s not required, it may be a good idea to complete a new W-4 each year. This is especially true if you usually owe tax with your Form 1040.

The total amount of federal income tax withheld during the year is reported to you on your W-2 in Box 2. The amounts from all W-2s are aggregated and transferred to the appropriate line of your tax return (Line 62 on the 2012 Form 1040). You may also have withholding reported to you on the 1099-series forms. Form 1099-R, which reports payments of retirement income, may show amounts withheld if part or all of the payments were taxable. Be sure to check these forms for withholding, or you might calculate too much tax on your return.

Quarterly estimated payments

If your withholding will not be sufficient to cover your tax liability, you can make estimated tax payments using Form 1040-ES. The due dates for estimated payments are:

• 1^st payment – April 15.
• 2^nd payment – June 15.
• 3^rd payment – September 15.
• 4^th payment – January 15 of the following year (e.g. the 4^th payment for the 2013 tax year is due January 15, 2014).

If the due date falls on a Saturday, Sunday, or federal holiday, the due date is moved to the next business day. A payment is considered timely filed if it is postmarked by the due date.

If you forget to make a payment or do not have funds to pay it on the due date, pay it as soon as you are able. You don’t need to wait for the next due date. The IRS will calculate interest based on the date it receives your payment.

You should consider withholding if you have significant taxable income from which income tax is not withheld. Common sources of such income include:

• Interest, dividends, and gains reported to you on Forms 1099-INT, 1099-DIV, and 1099-B.
• Non-employee compensation reported on Form 1099-MISC.
• Passthrough income from partnerships and S corporations reported on Schedule K-1.
• Net income of sole proprietors (including single-member LLCs) which will be included on Schedule C of your Form 1040.

In general, you should estimate the total amount of estimated tax necessary for the year, and make four equal payments. But, if you earn income unevenly through the year, you can make unequal payments. In this case you may need to file Form 2210 with your tax return to show how much income was earned by quarter.

Penalty for underpayment of estimated tax

If you fail to make sufficient payments of tax through withholding and quarterly estimates, you may be subject to a penalty. However, it can be difficult to make correct estimated payments. For example, if you have invested in a partnership, you typically won’t receive your Schedule K-1 until well after the time to make estimated payments. The IRS recognizes this and has established several safe harbors for estimated tax. If you meet one of these, you will not be subject to the penalty for underpayment of estimated tax:

• The tax due on your return (after considering your withholding) is less than $1,000.
• You had: (a) no tax liability for the prior tax year; (b) you were a U.S. citizen or resident for that entire prior year; and (c) that prior tax year was a full 12 months.
• Your withholding and timely estimates totaled at least 100% of your prior year tax liability, and your prior tax return was for a full 12 months and showed a liability.
  • NOTE: If your adjusted gross income (AGI) for the prior tax year was over $150,000 ($75,000 if married filing separately), this is increased to 110% of your prior year tax liability.
  • Tip: This method is useful for taxpayers with income that they can’t accurately estimate, such as income reported on 1099s or K-1s.
  • You paid (through withholding and/or timely estimates) at least 90% of your current year tax liability.
    • NOTE: If your quarterly estimates were not in equal amounts, you need to attach Form 2210 to your tax return.
    • Tip: If your income is down this year, this method can reduce your tax payments. But, you must be able to accurately estimate income from sources such as 1099s and K-1s.

Other considerations

• If you receive a larger amount of your income in the latter part of the year, you can make smaller payments in the beginning of the year if you file Form 2210 with your tax return.
• The IRS considers withholding to have been paid equally through the year, even if all of it was made in December. Taxpayers who must take a required minimum distribution (RMD) from a retirement account can defer some tax payments to the end of the year by designating all or part of their RMD to be withheld for federal income tax.
• As always, consult with your tax advisor to make sure you’re complying with the rules.