As we approach year end, we are are starting the process of determining our clients’ potential tax liability. It is important to always remember that the liability is different than how and when we pay the tax.
Individuals with substantial income in addition to their wages may find that the amount of tax withheld from their paycheck isn’t enough to cover their liability. The IRS imposes a penalty for “substantially” under paying the tax liability through out the year. The calculations for the penalty are a little cumbersome, but basically it is calculated like interest based on the applicable federal rate. This rate is adjusted each quarter. For 2012, the overall impact is about 1.5% of the tax under paid.
An effective way to avoid this penalty is to increase your withholdings before year end to cover any potential underpayment. The IRS treats withholdings, even if paid on the last day of the year, as being paid evenly through out the year.
Say your tax liability for 2012 is $15,000 (the same as it was in 2011). Assume you have wages, but have not withheld any amounts for the year. You would be required to make quarterly estimated payments of $3,750 to avoid the penalty. This amount could be higher based on your income, but we’ll keep it simple for this illustration. Assume you did not make any estimated payments during the year. Your under payment penalty would be $225. Instead, we could consider (assume all the math works out) to pay the tax from our paycheck or retirement distributions. Assume we are going to receive a year end bonus on the last day of the year. We could withhold $15,000 for federal tax purposes and avoid the penalty.
Please remember that there are similar rules for most states. Although the amount that we pay to the state is usually lower than the federal liability, the rate is usually significantly higher. For instance in Georgia, the underpayment penalty currently equates to about 6% of the underpaid tax.
If you have any questions regarding these penalties or would like to do year end planning to minimize your tax liability, please do not hesitate to contact us.