Structure your tax payments to make better use of your money
UNDERSTANDING your personal federal estimated tax payments and withholding can keep more of your money in your pocket longer.
Paying a small amount of taxes with your return allows you to use your money throughout the year and avoid underpayment penalties at year end. By analyzing your income throughout the year and structuring your withholding and estimated tax payments accordingly, you can pay just the right amount of taxes and avoid giving the IRS an interest-free loan.
As a general rule, you are required to pay a minimum amount of tax each year. That required amount is equal to the smaller of 90 percent of your total expected tax for the current year or all of the total tax shown on your prior year 12-month tax return. However, special rules apply for high-income taxpayers (adjusted gross income over $150,000 for married filing jointly), who must pay 110 percent of the total tax shown on their prior-year tax return.
If you fail to pay the full amount of your required annual payment, you may be subject to underpayment penalties on your income tax return.
Even if you pay the full amount of your required annual payment by year end, you still may be subject to underpayment penalties if you did not pay the minimum amount required quarterly.
The minimum amount required each period is equal to 22.5 percent of your current year liability, 25 percent of your prior-year liability or 27.5 percent of your prior-year liability if you are a high-income taxpayer.
Underpayment penalties are figured separately for each period according to the number of days the underpayment remained unpaid. The annual penalty rate for 2007 is 8 percent.
TO REDUCE or eliminate underpayment penalties, you should structure your withholding and estimated tax payments accordingly.
Withholding taxes are viewed as paid over the course of the year regardless of when the taxes were actually withheld. Therefore, if you think you have underpaid your taxes and it is near year end, you may be able to adjust your withholdings to avoid an underpayment penalty. Adjustments to your withholding are made through your employer.
Estimated tax payments are due quarterly (April 15, June 15, Sept. 15 and Jan. 15 of the following year). You must pay estimated taxes if you expect to owe at least $1,000 on your income tax return after taking into account withholding and credits.
You can use one of the two following methods to figure your estimated tax payments for each period:
» The regular installment method is best for taxpayers who receive income steadily throughout the year. This method calculates your required payment for each period by dividing your annual tax due by four; therefore, you pay your estimated tax in four equal installments.
» The annualized income installment method is best for taxpayers who do not receive income evenly throughout the year. The annualized method calculates your payments by annualizing your tax for each period based on amounts actually received and paid during each period.
For example, if your income is much larger July and August than during the rest of the year, your estimated tax payment due September 15 will be larger than payments made earlier and later in the year, when income is lower.
Kenneth Kretzer is a senior tax manager for the Honolulu office of Grant Thornton LLP. He can be reached at email@example.com