Taxpayers clearly aren’t paying enough attention to estimated tax penalties. A recent IRS Fact Sheet reveals that the number of people paying such penalties jumped nearly 40% from $7.2 million in 2010 to $10.0 million in 2015. In particular, individuals with substantial income in addition to salaries may find that the amount of tax withheld from their salaries isn’t enough to cover their required estimated tax payments. This may be the result of miscalculation or forgotten surprises—for example, a windfall on the sale of a capital asset earlier in the year, or unexpected exposure to the 3.8% surtax on net investment income. Also, an adjustment to withholding or estimated tax may be warranted by the additional Medicare tax. As this article explains, increased withholding, even at this relatively late time of the year, as well as a creative workaround, may stave off an estimated tax penalty.
Estimated tax basics. An individual must make four quarterly installment payments of estimated tax based on the amount of his or her “required annual payment” to avoid an underpayment penalty. In general, the required annual payment is the lesser of 90% of the tax shown on the current year’s return, or 100% of the tax shown on the previous year’s return. However, if an individual’s previous year’s return showed adjusted gross income exceeding $150,000 ($75,000 for marrieds filing separately), the required annual payment is the lower of 90% of the tax shown on the current year’s return, or 110% of the tax shown on the previous year’s return. Alternatively, a taxpayer may use an annualized income method to determine the required installments of tax if annualization results in lower quarterly payments.
The applicable test is applied separately to each installment. Thus, a taxpayer may be penalized for the underpayment of estimated taxes for any installment for which estimated tax payments made plus taxes withheld from the taxpayer’s salary (and from certain other payments such as pensions and annuities) don’t total at least 25% of his or her required annual payment.
Exceptions and waivers. The underpayment penalty doesn’t apply:
- If the tax shown on the return (or the tax due, if no return is filed) is less than $1,000 after reduction for federal income tax withheld, or
- If the individual was a U.S. citizen or resident for the entire preceding tax year, he or she had no tax liability for that year, and that year was a 12-month year or
- For the 4th installment, if the individual (who is not a farmer or fisherman) files his or her return by the end of the first month after the tax year (Jan. 31 for calendar year taxpayers), and pays in full the tax computed on the return, or
- In certain cases while a Title 11 bankruptcy case is pending.
The underpayment penalty may be waived by IRS if:
- Failure to pay was due to casualty, disaster, or other unusual circumstances where imposing a penalty would be inequitable or against good conscience or
- Underpayment was due to reasonable cause (not willful neglect), and the taxpayer retired (after reaching age 62) or became disabled during the year for which the payments in question were required or in the preceding tax year.
Complications due to the additional Medicare tax. An additional 0.9% Medicare (hospital insurance, or HI) tax applies to individuals receiving wages with respect to employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately). The tax is in addition to the regular Medicare rate of 1.45% on wages received by employees. The tax only applies to the employee portion of the Medicare tax.
Under Code Sec. 6654(m), the 0.9% additional Medicare tax is treated as a tax subject to estimated tax payment requirements. In the case of employees, the additional 0.9% Medicare tax is collected through withholding on FICA wages (or Railroad Retirement Tax Act (RRTA) compensation) in excess of $200,000 in a calendar year. Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. To the extent not withheld, the 0.9% additional Medicare tax must be included when making estimated tax payments.
The Medicare tax on self-employment income also is increased by an additional 0.9% of self-employment income that exceeds the same thresholds as apply for employees (see above). But the $250,000, $125,000, and $200,000 thresholds are reduced (but not below zero) by any wages taken into account in determining the additional 0.9% tax on wages.
Recommendation: Some taxpayers should consider having more income tax withheld or boost estimated tax payments if they have not had enough Medicare tax withheld. This could occur, for example, where an individual earns $200,000 from one employer during the first half of 2017, and a like amount from another employer during the balance of the year. The taxpayer would owe the additional Medicare tax, but there would be no withholding by either employer for the additional Medicare tax since wages from each employer don’t exceed $200,000.Also, in determining whether they may need to make adjustments to avoid a penalty for underpayment of estimated tax, individuals should be mindful that the additional Medicare tax may be overwithheld. This could occur, for example, where only one of two married spouses works and reaches the threshold for the employer to withhold, but the couple’s income won’t be high enough to actually cause the tax to be owed.
Late date fixes. An individual who has underpaid an estimated tax installment can’t avoid the penalty by increasing his or her estimated tax payment for a later period (although payment in a later period will reduce the period for which the penalty applies). However, increased withholding may resolve the problem.
Income tax withheld by an employer from an employee’s wages or salary is treated as paid in equal amounts on each of the four installment due dates unless the individual establishes the dates on which the amounts were actually withheld. Thus, if an employee asks his or her employer to withhold sufficient additional amounts for the rest of the year, the penalty can be retroactively eliminated. This is because the heavy year-end withholding will be treated as paid equally over the four installment due dates.
Illustration Jennifer expects her 2017 tax liability to be $15,000. Her 2016 return showed a liability of $14,000. Her withholding for 2017 will total only $10,500, and she has made no estimated tax payments. If she makes an additional estimated tax payment of $3,000 on January 17 of 2018, she will avoid any underpayment penalty for the last installment ($10,500 plus $3,000 equals $13,500, which is 90% of $15,000), but she would still be penalized for underpaying the first three installments. But, if instead Jennifer has her employer withhold an additional $3,000 before the end of 2017, her total withholding ($13,500) will be treated as estimated tax payments of $3,375 on each of the installment due dates. Since $3,375 is 25% of $13,500 (90% of $15,000), the underpayment penalty would be completely avoided for all four installments.
Outside-the-box solution. Mandatory 20% withholding applies to any designated distribution that is an eligible rollover distribution (i.e., from qualified plans, qualified annuities, tax-sheltered annuities, and governmental Code Sec. 457 eligible deferred compensation plans). And for purposes of withholding procedures and the procedural and administrative rules under the Code that relate to withholding, such a distribution is treated as wages with respect to which there has been wage withholding.
Thus, an individual can take an eligible rollover distribution from a qualified retirement plan before the end of 2017 if he or she is facing a penalty for underpayment of estimated tax and the increased regular-wage withholding option described above is unavailable or won’t sufficiently address the problem. Income tax will be withheld from the distribution at a 20% rate and will be applied toward the taxes owed for 2017. The taxpayer can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2017, but the withheld tax will be applied pro rata over the full 2017 tax year to reduce previous underpayments of estimated tax.
Caution: This idea won’t work with an IRA because mandatory 20% withholding doesn’t apply to distributions from any IRA (see Instructions to Form 1099-R and 5498, (2016), p. 13).