Tax Strategies for Unknown Income

Whether you are a W-2 employee whose taxes are withheld throughout the course of the year, or you make estimated tax payments for yourself, all American taxpayers are expected to pay their income taxes on a regular basis throughout the course of the year, and the amount that they pay is predicated on the amount of money that they expect to make.

Unfortunately, not all employers withhold the correct amount of money. Likewise, it is often difficult to estimate the correct amount of taxes to send in on a quarterly basis when you have no idea how much you’re going to make throughout the course of the year. To address this problem, the IRS and most state tax departments have created a formula for payments that are considered “safe harbors” – as long as tax payments are made throughout the course of the year on a regular basis and meet one of the two safe harbor requirements, there will be no assessment of underpayment penalties. The two options are as follows:

  • If a taxpayer provides payments evenly throughout the course of the year that add up to 90 percent or more of the actual tax liability, there is no penalty assessed for any underpayment.
  • If a taxpayer provides payments evenly throughout the course of the year that add up to 100 percent or more of their actual tax liability from the previous tax year, there is no penalty assessed for any underpayment.  Married taxpayers who file jointly and whose adjusted gross income was $150,000 (or $75,000 if filing married but separate) are required to make payments that add up to 110 percent or more of the previous tax year’s actual tax liability.

These are both popular options, but unfortunately, not everybody is able to or successful in trying to meet these benchmarks. When underpayments occur, the IRS determines what penalty to assess on a quarterly basis. Though many people try to compensate in later quarters for their failure to hit the benchmarks in the earlier parts of the year, doing so does not impact the penalties – and those penalties are assessed at rates higher than penalties for later quarters because the government assesses fees in part based upon the length of time that they had to wait for their money.

Though it might seem as though this is a situation where you simply can’t win, there is a method of avoiding underpayment penalties that is available to those who withhold, and that is by making up for the shortfall at the end of the year by withholding a greater amount then you did in earlier quarters. This strategy works for one simple reason – the government looks at the total amount that is withheld during the course of a year and assumes that it was withheld equally through each payment.  As long as you have your end-of-year taxes withheld in an amount that will make up for your earlier deficit, you can escape having an underpayment assessed against you.

This is a plan that works, but can be difficult to implement, as the longer you wait to put it in place, the higher your withholding amounts will have to be in order to make up for what you should have paid into the system earlier – and the less take home pay you’re going to have for end of year expenses. This can be addressed by having withholding taken from alternate sources, including brokerage accounts, pension funds, and Social Security payments.

Determining exactly what your withholding should be early in the year is obviously the best way to circumvent this problem, but that’s not always possible. If your income is higher this year than last and you did not make the appropriate adjustments, or if you are for any reason anticipating underpayment penalties, contact our professional staff today to see what the best solution is for you. We are here to provide you with the advice that you need to minimize your tax burden.

Give us a call at (770) 268-3434 and let us help with your tax questions and planning.