Many of our clients are required to pay estimated taxes and it often comes to our attention that there may not always be a clear understanding of the mechanics involved in determining how much they are required to pay Uncle Sam during the calendar year.  

Anyone whose withholding and other tax credits comprise less than 90% of their total tax liability (including alternative minimum taxes owed), is required to make estimated payments during the year.  This general rule, however is subject to some important exceptions. 

Estimates are not required if:  a)  the total amount due after subtracting withholding and other credits will be less than $1,000; or, b) your total withholding and other credits add up to at least as much as the amount of tax you paid during the previous year.

So for example, if you have withholding on your wages that you anticipate will cover your tax liability for the year (at least up to 90%), you should not have to file estimated tax payments.  However, if during the year your spouse sells stock and incurs a $30,000 capital gain on that transaction, you will be required to make an estimated tax payment to cover the anticipated tax liability.

That payment could easily be calculated at $4,500 (the $30,000 capital gain at a 15% capital gain tax rate).  On the other hand, if your spouse's gain was only $4,000, the anticipated $600 tax ($4,000 at 15%) would not trigger the need for an estimated payment since it is less than the $1,000 minimum.

Safe Harbor Rules

You can always avoid paying estimated taxes if your withholding and other credits are expected to equal the amount of tax shown on your prior year tax return.  The safe harbor rules also allow you to avoid estimated taxes if you meet all of the following requirements:  

    a) you had no tax liability for the previous year
    b) you were a U.S. citizen or resident for the entire year, and
    c) your tax year covered a 12 month period.

Using the same case as above, let's assume that not only are your withholdings going to cover your anticipated tax for the current year (before the stock transaction), but that your withholdings will also equal or exceed your total tax owed during the previous year.  No matter what your spouse receives from the sale of his or her stock, you would not be required to make an estimated tax payment to cover the anticipated tax because you would fall under the safe harbor rule of paying at least the amount of tax you owed during the previous year.

You can exclude certain amounts such as the earned income credit and social security tax on tip income when you determine the "total tax" on the prior year's return, but most of these items apply to a fairly small percentage of taxpayers.

Safe Harbor Caveat

There is one hitch to the safe harbor rule described above.  Taxpayers with adjusted gross income above $150,000 on the prior year's return ($75,000 if married filing separately) are required to use a higher percentage of the prior year's tax when applying the prior year safe harbor. That higher percentage can change but is generally around 110% of the prior year tax.

Calculating The Required Estimates

Once we have an idea of the tax that you need to pay in to be "safe" (90% of the current year's tax or 100% of the prior year's tax), we typically examine your withholding amount to determine if it will meet or exceed the safe amount.  The difference between the safe amount and your anticipated withholdings and credits determines the amount of your required estimated payments.  

Of course, it isn't always necessary that your additional tax payments have to be made in the form of estimates.  You do have the option of simply increasing your withholdings to an amount necessary to cover the shortfall.  This is often the best alternative for taxpayers who do not have the discipline to make quarterly estimated payments.  

Please give us a call if you suspect that your current withholdings or estimated payments will not meet a safe harbor amount.  The penalties for underpayment of estimated taxes are excessive, but easily avoided with the proper planning.