In this video, Bridget and John discuss the ins and outs of making estimated tax payments to the IRS and provide valuable tips on how to stay out of hot water with the tax authorities. Whether you've had a windfall, started a business, or experienced a big financial change, understanding estimated payments is crucial. Join us to gain insights and avoid underpayment penalties.
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TRANSCRIPT:
Bridget: Are you concerned that you haven't paid enough into the IRS this year and think you might need to make an estimated payment and want to know more? You're in the right place. I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Before we dig into the details of how to stay out of hot water with the IRS, I want to remind everybody to hit that subscribe button. That helps other people find this information on YouTube. And with that, let's dig know. A lot of our questions at this time of the year in my practice (and I suspect the same might also be true for yours) revolve around this idea of making estimated payments to the IRS.
We often see this with people who have had a windfall of some sort. Maybe they’ve inherited some money and are now asking, “Am I going to owe some money? Do I need to make an estimated payment?” Or maybe they had stock options or their company went public, or they did a Roth conversion, or took some money out of my IRA. All these instances make people ask, “Do I need to make an estimated tax payment for fourth quarter by January 15?” I don't know if you're hearing a lot about those questions in your practice, but I'd be interested in your take.
Bridget: I've got more examples. I started a business this year, and I've got some income. And I got a big bonus, and they withheld, but I don't think they withheld enough. So those are all good examples of when you might need to make an estimated payment. Now, there're two ways to figure out estimated payments, which are generally just what the IRS want. The IRS would like to get paid equally during the year. They don't like to get paid all at once on April 15. And so, they say, “Pay us equally over the year. And that's what estimated payments do. They help you pay equally over the year.
John: And if I could jump in on that. It's sort of like when you're working, and you get a paycheck. What happens to your paychecks? They automatically withhold taxes every pay period; some money goes to the government for taxes when you're working, and you get a regular paycheck. But this is not the case for these instances we're talking about: I've got a business now; I'm making some money; I inherited money where there aren't any withholdings from your investment gains. If you're running a small business, maybe this is from your stock options. That's where those estimates come in. It's kind of like how most of us are used to withholdings from our paychecks, but estimates come in for those things that don't get withheld.
Bridget: Absolutely. And that's a good way to look at it. Usually, people know that they're in the estimated payment situation, but they're anxious about it. And it's like this whole subsystem. 90% of the people have never heard of estimated payments and will never hear of estimated payments because they just never have to do it and because they would have withholding directly from their paychecks, and then they get directly from their IRAs, and then directly from their Social Security, and they never have to do any payments.
So there's a lot of confusion when people start out because they think, “I've never even heard of this. And yet you're telling me this is common?” Yeah, it's common, but again, only 10% of the people need to do it at any given time. And probably only 30% of the population even know it exists because of the way that the tax system works. So how to figure this out? There're two ways to figure out how much estimated payments you need. And the first way, which I think is probably the most common, and it's certainly most common for the situations that we're describing to you, like big jumps in income, is look at your previous year’s taxes.
Right now, it's 2023, so we look at 2022 and make sure that you've paid in. If you are single and you make less than $75,000 a year, you need to make sure that you pay in 100% of last year's total tax. And if you make over $75,000 it's 110%. So you multiply the total tax last year, not how much of a refund you got or how much you owed, but the total tax, which is the number that most people don't have much relation to, but nevertheless that's what you want. The total tax last year times 100% or 110%. And if you're married, filing jointly, it's twice the $75,000, so it's $150,000. John, do you have anything to add there?
John: How you described it is exactly right. Those are the facts. I think of it as just saying, “Listen, if you pay in 110%, then you're safe.” Look at last year's taxes. It's on page two of the 1040 about a third of the way down or so “your total tax,” or something like that. And you go, “Oh, yeah, that's right.” You said it's not what you owed at the end of the year. That's what your tax bill was for the year. Most of it gets prepaid with those withholdings and things. Hey, I owed $20,000 in tax last year. This year if I pay at least $22,000 I'm safe.
The safe harbor is what they call that. As we're talking about this, Bridget, I realized that we did not define safe. What does safe mean? Safe from what? And we never talked about that when I was explaining why we need to do this. The reason is if you don't pay enough throughout the year, in either withholdings from your checks or in quarterly estimates, then the IRS will assess an underpayment penalty to you when you do your taxes in the spring. So to avoid that underpayment penalty, it's that 100% or 110% of last year's taxes are one of the metrics, right?
Bridget: Absolutely. And what is the underpayment penalty? First, I like to make sure that people understand that it's the least penalty. It's just interest. It's the lowest of anything that the IRS does as far as penalizing people. We'll put a chart up here. It is 7% for the first three quarters, and then 8%, and that's 8% annually. But that's for that quarter, and it's compounded every day.
I describe it to people as the IRS wanting to encourage you to get it out of your savings account and to the IRS. That's the motivation. It's not as much to punish you as it is to encourage. There're many other IRS things that are punishment, but not really this one. I try to lower the anxiety level with people a little bit that way.
John: I appreciate that. And, well, folks, sometimes you do end up paying a small underpayment penalty. And when you hear penalty, it gets people anxious, but the IRS doesn't care. It's not a red flag, like you're cheating on your taxes or something like this, as you just described. This isn't punishment. It's more like saying, “We want our money and we got to charge you interest on that.” I've had folks in the past that say, “Listen, the underpayment interest rate penalty is 7%.
Well, shoot. I'm going to leave my money invested, and more times than not, I'm going to get more than 7%. I'll get 10% of my investments, and I don't care about the penalty.”
I'm not sure that I subscribe to that personally, but it's not like you're cheating. It's just what the rules are, and if you follow the rules, it's not a big deal from that standpoint. I really appreciate that viewpoint, Bridget. You had mentioned that there're two ways that you can avoid this underpayment penalty. One is paying 100% or 110% of last year's taxes. What's the other method?
Bridget: The second way is to pay 90% of what you ultimately owe this year. So that means you have to have a decent projection of what you're going to owe this year. And if you've got a small business, it can be surprisingly different than what you think it's going to be. So it can be a little bit harder to get your finger on exactly what that number is. But you can usually get approximate. In those cases, I try to help people approximate, by asking, “What do we think the total tax is going to be?” Even if you know it’s less than last year.
Maybe I know my income is going down. Here's what my tax was last year. Okay, what do I think it'll be this year? I know what my income is. Just do some sort of proportion there, and that, again, can get you to the 90%. Another maybe a little-known fact, John, is that you get out of jail free card, or maybe that's bad wording within this context, but the year you get married, you're not subject to this; you've got an exception, because the IRS can't keep track of two tax returns.
There's a button to click, and then you should be good with underpayment penalty on the year that you get married. The other thing is that if you get a lot of money at the very end of the year, then the IRS, if you don't say that this is all at the end of the year, by doing what's called an annualized statement, an extra form. And in that form, you show exactly when you got all the different parts of money. It's kind of a pain to fill it out. I filled it out a lot when it's high. If it's $100, I probably wouldn't bother filling it out.
So your tax preparer might have some sensitivity to that, because it's a somewhat time consuming form to figure out, because you have to figure out how much does the taxpayer have on all these arcane time frames, such as the first three months, then the first five months. Who divides by five months? When do you have to have your income sliced and diced that way—and all your deductions? It's not crazy, but it does probably take some time to do so unless it's a large amount, preparers might just say, “Hey, pay it.”
John: Are you saying that the IRS rules aren't completely logical and orderly? Is that what I'm hearing? I might make a note of that. 😊
Bridget: Yeah, it's true.
John: It's a weird thing. I'm glad you brought that up because we've had some folks, especially as we're here getting towards the end of the year, asking, “Do I need to make a fourth quarter estimate?” A lot of times it's for doing things like Roth conversions. We took money out of our IRA and put it into Roth, or we've got a year-end bonus and maybe they withheld some taxes, but not quite enough from that. And as you just described, we've had folks that have Roth conversion and it's $200,000 of extra income. The IRS looks at that and says, “Oh, you made an extra $15,000 or $18,000 each month throughout the year.
You owe us taxes going back to January for underpayment. And you go, “Wait a minute. No, I got all that income in December. I just have that one month. And I made an estimated payment for the fourth quarter, so it matches those things up.” So I think the important takeaway for folks is if you have income that came in during the end of the year, as we're talking about now, make sure you let your tax preparer know that it wasn't received in January or April but in the fourth quarter, so they can make that form and make a decision on getting that filled out and avoiding some of those penalties.
Bridget: Absolutely. The last thing I want to mention is that you should also be mindful of your state if your state levies income tax. I'm in Illinois. It's easy to figure out how much to withhold in Illinois because it's a flat tax. And I can easily see, okay, I just need to make an estimated payment for interest, dividends, small business. IRA and Social Security are not taxed in Illinois. It's easy to figure out. Illinois and withholding usually cover exactly what they need from their W2.
So with Illinois, the thing is that it's a smaller amount because the Illinois tax is obviously lower than the federal tax, but the penalties are worse. They don't have this 7%, so it’s not a matter of saying, “Oh it’s the lowest penalty ever.” Rather, it’s a matter of them saying, “We want you to pay.” I encourage people to pay all of Illinois’ tax. Don't wait. Don't even mess around. Give yourself cushion. So that's my two cents. I want people to think, “Don't forget about my state.”
John: That's awesome. We're talking about avoiding federal underpayment penalties with that. Follow the things that we've laid out here, and make sure you pay attention to the states.
Bridget: There's one more bonus before I say, “Please subscribe,” and that is, if you're going to owe less than $1,000, you don't have to do it.
John: Oh, great. Yeah, don't worry about that.
Bridget: With that. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Both Bridget and I are taking on new clients. We'd love to hear from you, but if you like what we have to say, you'd like to look for an advisor in your local area. We're both members of the Alliance of Comprehensive Planners, so if you'd like to find a planner who thinks like us in your local area, go to acplanners.org.
Bridget: And please subscribe.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.
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