Taxpayers are required to prepay their taxes for the year through withholding or estimated tax payments. The amount that must be paid in advance is an amount equal to the lesser of 90% of the current year’s tax liability or 100% of the prior year’s tax liability. Higher-income taxpayers, those with a 2009 AGI of $150,000 or more, are required to prepay the lesser of 90% of 2010’s tax liability or 110% of 2009’s tax liability. There is no penalty if the amount of federal tax due is $1,000 or less. (The threshold amount and required payment percentage rules may differ for state purposes.)
The penalty is figured on a quarterly basis. Generally, the prepayments for each period must be commensurate with the income for that period. Estimated tax payments are credited in the period paid. Thus, an individual who has underpaid an estimated tax installment can’t avoid the penalty for that period by increasing his estimated tax payment for a later period (although payment in a later period will reduce the penalty for the quarter in which the payment was made).
However, income tax withholding is treated as being paid ratably over the entire year no matter when it was withheld. Thus, if you are underpaid for income received earlier in the year, you can possibly make up the shortage by increasing your withholding late in the year.
So, if you are an individual who had an income windfall earlier in the year and did not prepay taxes on that windfall, and your current withholding level will not cover the additional tax liability, it may be appropriate to increase withholding late in the year. The strategy will apply to any circumstance where your 2010 tax return will result in a tax due in excess of the threshold mentioned earlier. The following are two techniques that can be used to substantially increase your withholding in the latter part of the year.
- Increased Payroll Withholding – If you are a salaried employee, you can have your employer withhold extra amounts from your payroll. This is the simplest and most convenient approach. The IRS Form W-4 allows you to designate specific amounts to be withheld each pay period. If necessary, your entire check after other taxes and withholding can be credited to Federal withholding tax. Contact your payroll department or company accountant.
- Eligible Rollover Distribution – Another possible option for a taxpayer who has underpaid estimated tax is to take an eligible rollover distribution from a qualified plan before the end of 2010. When distributions are made by direct transfer (not a trustee-to-trustee transfer), 20% federal withholding is required and will be applied toward the taxes owed for 2010. The gross amount of the distribution (the amount of the distribution before the withholding) can then be timely (within 60 days) rolled over to a traditional IRA. No part of the distribution will be includible in income for 2010, but the withheld tax will be applied pro rata over the full tax year to reduce previous underpayments of estimated tax. It is essential to timely complete the rollover to avoid paying tax on the distribution and possibly being subject to an early withdrawal penalty.
Other Forms of Withholding – The same rules described above in regard to amounts withheld from payroll also apply to overpayments of Social Security taxes and to income taxes withheld from: supplemental unemployment compensation benefits, sick pay, pensions, annuities, investments, gambling, etc.
If you think your taxes may be underpaid for the year and would like assistance in avoiding an underpayment penalty, please give the office a call as soon as possible.