The IRS expects you to pay your taxes not on April 15 but throughout the previous year as you earn your money. If you owe more than $1,000 for 2006 when you file your tax return and the amount owed is more than 10% of your total tax bill, the IRS will assume you failed to pay on time and may slap you with an underpayment penalty. However, there are several exceptions to that penalty and only by going through this interview can we determine if you qualify for one of the exceptions. See Underpayment Exceptions.
The IRS generally expects you to pay your entire estimated tax bill in four installments during the year. If any payment is short or late, the penalty rate is applied on a daily basis until you pay up. If you ignore the first payment and double up on the second, for example, you would still owe a penalty based on the number of days the skipped payment was overdue.
The penalty works like interest on a loan, with the penalty rate applied to the amount of estimated tax due but unpaid by each of four payment dates during the year. The penalty rate is set by the IRS and can change each quarter. In the fall of 2005, it was 7%.
Employees have an extra, and particularly potent, way to avoid the underpayment penalty. Say you discover late in the year that you should have been making estimated payments all along on your investment income. Even if you make up for the oversight with a big estimated payment for the final quarter, the IRS will stick you with the penalty for missing earlier installments.
However, if your employer will increase withholding from your salary so that the total withheld will cover 90% of your tax bill — or (for most taxpayers) 100% of the total tax due for the previous year — you can retroactively eliminate the underpayment penalty. Unlike estimated payments, which are considered paid when they are paid, withholding is treated as though it is taken out evenly throughout the year. To initiate penalty-saving overwithholding, you need to file a new W-4 form with your employer. If you use this technique, remember to file another W-4 in January to bring withholding down to the proper level. For help filing a new W-4, see the help for Withholding Allowances or complete the interview for Employee Withholding. This same withholding gambit can help you avoid an underpayment penalty on retirement payouts from individual retirement accounts. Amounts you have withheld late in the year are treated as having been withheld evenly throughout the year, so you can skimp on payments early in the year and withhold heavily later on. It takes some effort, but lets you hold on to more of your money longer.
Retirees taking distributions for IRAs can also use a year-end boost in withholding to avoid an estimated tax penalty. You can direct your payer to withhold any amount from a December IRA distribution, for example. So, if you learn you're coming up short for the year — or use this last minute withholding to cover all of your estimated tax payments — you can pinpoint the amount to be withheld to cover you tax bill.
Taxpayers who earn at least two-thirds of their gross income from farming or fishing—professions for which projecting income is notoriously difficult—are covered by special rules. Rather than being required to make estimated payments during the year, farmers and fisherman can pay their estimated taxes in a single payment, due January 15 of the following year.
To avoid the underpayment penalty, that payment must be just two-thirds of the actual tax liability for the year, or 100% of the tax owed on the previous year's return. Farmers and fishermen can even skip the January 15 payment without penalty if they file their returns and pay the full tax due by March 1.
The following exceptions can protect you from the underpayment penalty.
Although the general rule calls for your minimum tax payments to be made in equal, quarterly installments, the law does recognize that in some cases that would make no sense. Say, for example, that the only reason you need to make an estimated payment is a $50,000 profit on a stock sale in mid November. Why should you make an estimated tax payment on that income the previous spring? You shouldn't, and you don't have to.
Under the "annualized income'' exception to the underpayment penalty, the amount due on each payment date can be based on the actual amount of taxable income you have received at that point during the year. Although it involves some extra number crunching, the annualized income approach can save you from a penalty due to a bulge in income during the latter part of the year.
For most taxpayers, the penalty is waived—no matter how much you owe with your return—if your payments for the year equal your tax bill for the previous year. Even if your income took an enormous jump in 2006, thanks to a big profit on an investment, say, this exception lets you ignore estimated taxes if the amount withheld on your salary will be at least equal to the amount you owed for 2005.
However, if your 2005 AGI was over $150,000, you have to pay in at least 110% of what you owed for 2005 to use this exception to the penalty in 2006.
Regardless of your income, you are protected from an underpayment penalty if your payments for the year equal at least 90% of your actual tax bill—assuming your payments were made via withholding or, if you made estimated payments, that you made those payments on time.
If you owed no tax in the previous year—and were a U.S. citizen or resident for the whole year—you don't have to make estimated payments regardless of how much tax you'll owe. This applies only if you had no tax liability in the previous year, not if you just didn't have to pay extra tax with your return.
Note this: If you may be vulnerable to an underpayment penalty, be sure to go through the Interview on this issue so the program can determine if you qualify for one of the exceptions.