Our tax system is a “pay-as-you-go” system, and if your pre-paid amount is not enough, you become liable for non-deductible interest penalties. To facilitate that concept, the government has provided several means of assisting taxpayers in meeting the “pay-as-you-go” requirement. The primary among these include:
- Payroll withholding for employees;
- Pension withholding for retirees; and
- Estimated tax payments for self-employed individuals and those with other sources of income not covered by withholding.
Determining how much tax to pre-pay through withholding and estimated tax payments has always been difficult, but thanks to Congress’ constant tinkering with the tax laws, usually in late fall, ensuring there are no underpayment penalties or tax surprises when the tax return is prepared next year merely adds complexity.
One of the biggest unknowns for 2012 is the alternative minimum tax (AMT). Beginning in 2001, the exemption to the amount of income not subject to AMT was substantially increased and inflation-adjusted in subsequent years. However, the increased exemption amounts are not permanent and must be extended by Congress on a year-by-year basis. So far Congress has not acted for 2012, and if they do not, the AMT exemption will revert to 2000 levels, roughly one-half of the current amount. Without Congressional action an estimated 30 million taxpayers, approximately 20% of all taxpayers, will be hit by the AMT in 2012. Compare this to the roughly 600,000 taxpayers in 1997 (approximately 1% of all 1997 taxpayers) who were affected by the AMT.
When a taxpayer fails to prepay a safe harbor (minimum) amount, he or she can be subject to the underpayment penalty. This penalty is the short-term federal rate plus 3 percentage points and the penalty is computed on a quarter-by-quarter basis. So, even if you pre-pay the correct amount for the year, if the amounts are not paid evenly you could be subject to a penalty. Interestingly enough, withholding amounts are treated as paid ratably throughout the year, so taxpayers who are underpaid in the earlier part of the year can compensate by bumping up their withholding in the later part of the year.
Federal tax law does provide ways to avoid the underpayment penalty. If the underpayment is less than the $1,000 de minimis amount, no penalty is assessed. In addition, the law provides “safe harbor” prepayments. There are two safe harbors:
- The first safe harbor is based on the tax owed in the current year. If your payments equal or exceed 90% of what is owed in the current year, you can escape a penalty.
- The second safe harbor is based on the tax owed in the immediately preceding tax year. This safe harbor is generally 100% of the prior year’s tax liability. However, for a higher income taxpayer whose AGI exceeds $150,000 ($75,000 for married taxpayers filing separately), the prior year’s safe harbor is 110%.
Example: Suppose your tax for the year is $10,000 and your prepayments total $5,600. The result is that you owe an additional $4,400 on your tax return. To find out if you owe a penalty, see if you meet the first safe harbor exception. Since 90% of $10,000 is $9,000, your prepayments fell short of the mark. You can’t avoid the penalty under this exception.
However, in the above example, the safe harbor may still apply. Assume your prior year’s tax was $5,000. Since you prepaid $5,600, which is greater than 110% of the prior year’s tax (110% = $5,500), you qualify for this safe harbor and can escape the penalty.
If your state has a state tax, the safe-harbor amount may be a different percentage.
This example underscores the importance of making sure your prepayments are adequate, especially if you have a large increase in income. This is common when there is a large gain from the sale of stocks, sale of property, when large bonuses are paid, when a taxpayer retires, etc.
If you have questions regarding your pre-payments or would like to review and adjust your W-4 payroll withholding, W-4P pension withholding, and estimated tax payments to provide the desired tax result for 2012, please give this office a call.