YEAR-END TAX STRATEGIES FOR MAKING ESTIMATED PAYMENTS

Making accurate estimated tax payments for income not covered by employer withholding can easily be overlooked or miscalculated. But you can eliminate or reduce potential penalties by making some adjustments before the end of the year.

First, some basics. Estimated taxes generally are paid on income not subject to employer withholding, such as self-employment and investment income, stock options, pension benefits and Social Security, and withdrawals from qualified retirement accounts. You’ll also likely need to make estimated payments on that income if you expect to owe $1,000 or more on your federal 2002 return (and possibly your state return) above the amount that’s withheld from your paychecks (plus any credits), or withholding and credits won’t cover at least 90 percent of your expected 2002 tax bill or 100 percent of what you paid in 2001. (For taxpayers with adjusted gross income over $150,000 in 2001—$75,000 for married filing separately—the “safe harbor” is 112 percent of 2001’s total tax bill.)

Calendar-year taxpayers usually make their estimated payments four times a year: April 15, June 15, September 15 and January 15 following the tax year (except when those dates fall on a weekend or holiday). Fiscal-year filers also make four payments but on a different schedule. Taxpayers who earn two-thirds of their income from farming or fishing only have to file on January 15.

The trick is calculating the right amount of estimated payments to make each quarter to avoid underpayment resulting in penalties, or overpayment resulting in a large tax refund in April. This is easy if income is stable from year to year. You can use either the 90, 100 or 112 percent safe harbors and spread out your four payments evenly.

Getting the 90 percent right can be tricky, so the 100 or 112 percent methods are the safest. The major problems they present is if you earn significantly more this year than last, you’ll likely end up with a large tax bill come next April 15, or if income is significantly less than the previous year, you’re paying out far more in taxes than necessary. You’ll get the extra back, but not until the following spring when you file.

At this point in 2002, you have only a final payment to make for the tax year—January 15. What if you realize you haven’t paid in enough? Perhaps you forgot to include the capital gains you made on the sale of an investment earlier in the year, or you plan on making a profitable sale between now and December 31. Or perhaps you’ve neglected to make estimated payments at all for the year. Another common error occurs when one spouse works for an employer and the other earns self-employment income. The taxes withheld from the employed spouse may reflect only the income-tax bracket of that spouse, not the tax bracket reflecting the couple’s combined income, which could be higher. Hence, not enough is withheld from the spouse’s paycheck.

You can, of course, catch up with your January 15 payment. The only hitch is that the IRS takes your total estimated payments for the year and divides by four for a quarterly average. If any of the previous payments were under that quarterly average, you’re subject to a penalty tax on the difference. Consequently, a big catch-up on January 15 could still result in penalties—even if you don’t owe any additional tax for the year!

Fortunately, the penalty is not steep, but it is something to avoid. Taxpayers subject to withholding have a way out. You can have your employer increase your withholding taxes—even if it’s just for the last month of the year—enough to cover your shortfall and you won’t face a penalty. Just remember to readjust the withholding starting in January. The same strategy also applies to any retirement plan, such as a 401(k) or individual retirement account. You can direct the institution to withhold up to 100 percent of the withdrawal for taxes.

Another option is to increase deductions in 2002 or delay taxable income into 2003. You may be able to do this with self-employment income or by delaying the sale of an investment or exercise of stock options, as long as it makes investment sense. You also should take into account the alternative minimum tax and recent tax changes. Because of the complexity, consider consulting your financial planner or tax specialist.

November 2002— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by  McGuire & Co., LLC, a local member in good standing of the FPA.