Avoiding penalties

In case you missed the frantic calls from your accountant, let me remind you that tomorrow is the deadline for most of us to submit our taxes.

When reviewing the return (and yes, you should review it!), you may notice that there may be an estimated tax penalty computed for you in the section marked “Amount You Owe.”

In my experience, few clients know why they owe this penalty, how to avoid it and even why sometimes it’s all right to embrace the penalty! Whether you use an application to prepare your taxes or hire a professional, you probably will receive a set of estimated tax vouchers. Do you ignore the vouchers, or should you pay the IRS (and the state) four times a year?

So, what is an estimated tax penalty? The federal tax scheme is a pay-as-you-go system. While some countries are patient enough to wait for their taxes until the end of the year, the IRS wants to be paid as you earn the income. If you end up owing significant amounts when you file, then the IRS levies this penalty to make up for the fact you have not been paying enough throughout the year.

I wish the IRS (or perhaps this would take an Act of Congress) would call it interest, as that’s what this “penalty” is. The IRS charges an annual rate of interest based on prevailing rates. With the recent run-up in interest rates, it’s 8% annualized interest. This is why many more people are noticing these penalties than before. A few years ago, the interest rate was only 3%. The IRS computes this interest for you by looking at the timing and amount of payments you should have made and what you actually did make. Any gaps between them are then charged interest based on the timing of your payments.

If you aim to minimize the interest you pay the IRS, three safe harbor rules can keep you in the clear if you follow at least one of them. The first rule applies if you owe less than $1,000 on your taxes when you file. The second rule is you pay at least 90% of your tax bill throughout the year. The final rule states you’re in good shape if you have paid 100% of the previous year’s total computed tax (110% for those with at least an AGI of $150K for married couples of $75K for single filers). All the safe harbor rules depend on you making payments through tax withholdings and equal estimated tax payments.

The third rule is the only one that allows you to look back at your previous year’s taxes to see how much you must pay the IRS to escape a penalty. As an example, let’s assume you’re a married filer with an AGI of $170,000 in 2023. When you look at your 2022 federal taxes, the total tax was $30,000. That means if you withhold and make estimated tax payments of at least $33,000 in 2023, you will not owe any estimated tax penalties.

So, what can you do in future years to escape penalties? You can boost the tax withholdings from your paycheck, Social Security, pension payments and retirement plan distributions. Also, you can make estimated tax payments throughout the year. I’m referring to those vouchers that are printed out with your tax return. You must make equal payments on dates close to April 15, June 15, September 15 and January 15 if your income is earned evenly throughout the year.

But for some entrepreneurs, the 8% interest may be the lowest one they can qualify for. It probably doesn’t make sense to carry balances on credit cards that are charging 25% interest just so you can avoid estimated tax penalties, which are loans from the IRS at 8%.

If you do take the IRS up on its offer to lend you the money, don’t forget that it is not a creditor to be trifled with. As a colleague once quipped, “They are a lender who have guns and can take your stuff.” So, know what you’re getting into before you skip required estimated tax payments. For more complicated situations, consulting a tax professional is best to help keep you out of trouble.