AVOIDING AN UNDERPAYMENT PENALTY

The Internal Revenue Service wants you to have 90% of your current year’s tax liability, or either 100% or 110% of the prior year’s tax liability (depending on the amount of your prior year’s Adjusted Gross Income), paid in during the year via withholding or quarterly estimated tax payments.  If you owe too much when your file your 1040 you could be hit with a penalty for “underpayment of estimated tax”.

There is a special year-end strategy you can use to avoid such a penalty.

First some background:

Timing is important when it comes to paying your taxes.  The underpayment penalty is calculated based on quarterly payments.

Withholding is assumed to be made evenly throughout the year.  Even if you have all your federal income tax withheld in December it is treated as being paid in equally over the 4 quarters for purposes of determining underpayment.  If you had $10,000 withheld in December it is assumed that $2,500 was paid in for each of the 4 quarters.

Estimated taxes are applied in the calculation when actually paid. If you discover you need to pay $10,000 in estimated tax for the year and you make the payment in December you will still be penalized for underpayment for the first 3 quarters.

There is an exception.  If the reason you will owe the additional $10,000 is because you sold a vacation home in November for a substantial gain you can make the payment as late as mid-January and avoid the penalty by "annualizing” your income.

Now for the strategy:

Suppose in the course of preparing your "preliminary" 2011 tax return (see my earlier article on Year-End Tax Planning) you discover you did not have enough federal income tax withheld from your paycheck and you will owe Uncle Sam at least another $10,000 because of additional income received at various times during the year.  Instead of making a 4th quarter estimated tax payment, and risking a penalty for underpayment of estimated taxes, you can –

(1) Take a $10,000 distribution from an IRA in December and elect to have 100% of the distribution ($10,000) withheld for federal income taxes, and

(2) Within 60 days deposit $10,000 to another IRA, or back into the same IRA (you shouldn't wait the full 60 days – do the rollover ASAP). Make sure that you rollover the $10,000 on time - or else you will be hit with additional tax and another, more expensive, penalty!

Because federal income tax withholding, from whatever source, is assumed to be made evenly throughout the year, regardless of the date of the actual withholding, your $10,000 will be treated as 4 equal quarterly payments of $2,500 and you will avoid the penalty for underpayment of estimated tax.

This strategy may also work for state income tax underwithholding.

TTFN