One of the things you’ll probably end up dealing with sooner or later as a successful investor is paying estimated income tax. When starting out, most people fall into one or more of these three investing categories.
- Starting with such small amounts that any interest, dividends, and/or capital gain/loss is inconsequential in relation to the amount of money they make from income sources that have automatic income tax withholding, such as their day job.
- Are investing only in tax sheltered accounts such as a 401(k) or IRA, where capital gains taxes are not an issue.
- Are regularly losing money year after year due to poor investing technique and so never have to worry about paying capital gains tax.
However, at some point (hopefully) you are investing in a way that is building a sizable capital base and income stream relative to your day job income. Due to annual contribution limits for 401(k)s and IRAs, over time more and more investment capital will likely make its way to taxable accounts. At that point, taxable income that doesn’t have any automatic tax withholding such as interest, dividend payments, and capital gains, can make up a noticeable slice of your total annual income.
While you will be very pleased with this development (and you should be), the IRS will be expecting its share. More to the point, the IRS will be expecting its share through the year as you earn this money, just like the IRS takes its share from your salary through the year via withholding.
If you realized a huge capital gain early on in the year, the IRS is not going to be happy that it had to wait until April 15 of next year to get its share of that. So it’s time to look at paying quarterly estimated taxes.
Here’s the estimated tax schedule for 2015. Notice that the year is not broken down evenly. The spring quarter is short and the winter quarter is long:
- Q1: 1/1/2015 to 3/31/2015, Tax Due 4/15/2015
- Q2: 4/1/2015 to 5/31/2015, Tax Due 6/17/2015
- Q3: 6/1/2015 to 8/31/2015, Tax Due 9/16/2015
- Q4: 9/1/2015 to 12/31/2015, Tax Due 1/15/2016
The IRS can make you pay a penalty if you’re supposed to pay estimated taxes and don’t pay them at all or don’t pay enough. Essentially, the penalty is the interest owed on the unpaid taxes from the date you owed the tax until the date you actually paid the tax. The interest rate varies, reset every quarter based on short-term interest rates. At the time I write this, the interest rate the IRS is charging is 3% compounded daily.
When to worry about estimated tax payments
So what’s the threshold where you’d even have to worry about underpayment penalties in the first place? The IRS defines the bar as:
If you did not pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they owe less than $1,000 in tax after subtracting their withholdings and credits, or if they paid at least 90% (100% for people with AGI’s of $150,000 or higher) of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller.
Let’s say you sold a stock for a long-term capital gain of $2,000. If you’re making $50,000 a year from a job that is having income tax withheld from it, the $300 you owe in long-term capital gains taxed at the 15% rate likely won’t push you anywhere near the threshhold where you’d owe a penalty.
Another example: if you’re making $50,000 a year and have $5,000 in the bank making 1% interest, that extra $15 in taxes owed on the $50 you made very likely isn’t going to push you into penalty territory either.
So the first step is to do a reality check and keep track every year just what percentage of your income is coming from sources that don’t have withholding (you have to do this anyway when you file your taxes). If you’re nowhere near the minimums, you don’t have anything to worry about. If you’re starting to flirt with the minimums then it’s time to tackle the estimated tax problem.
How much to pay in estimated taxes
I like to split the problem of estimated taxes into two buckets: regular, repeatable, easily estimable income (interest, dividends, and my freelance income) and sporadic income (capital gains). Since I still work a day job, I just increase my withholding on my W-4 to cover the repeatable stuff and avoid having to deal with estimated taxes.
If you no longer work, you’re likely filing estimated taxes already and would just add dividend and interest income to the other income sources you are already listing, such as retirement income and Social Security.
Unlike dividends and interest income, capital gains are sporadic.
I have no clue when or if I’m going to sell anything in the coming year or what price I might be able to get for it. I don’t want to pre-pay a large amount of tax, either through withholding at work or through evenly-divided estimated tax payments.
When you pay estimated tax you have the option to either pay in regular, evenly-divided quarterly chunks or pay precisely what you owe each quarter.
The IRS prefers the regular payments, and that works pretty well for retirees and the freelancers and independent contractors who have regular enough work that they can estimate what their tax liability will be.
If you’re sending in lumpy payments due to capital gains, you’ll likely need to fill out federal form 2210 and the state version. On this form you detail out your income, withholding, and estimated taxes for each quarter, proving to the IRS that you paid all the taxes you were supposed to and when you were supposed to.
Some handy links:
Federal Estimated Tax Forms
Federal Online Filing:
failure to pay penalties:
— Answer provided by Motley Fool member Mike Sandrik