Hardly a day goes by when you don't pay some sort of tax. Whether it's payroll taxes taken out of your paycheck, sales tax when you go shopping, gasoline taxes when you fill up at the pump, or property taxes you pay with your mortgage every month, there's always somebody grabbing at your wallet. Although the Tax Foundation announced that its Tax Freedom Day occurred way back on April 26, that doesn't mean that you won't keep paying taxes throughout the year.
Getting hit with penalties and interest on your taxes just adds insult to injury. If you don't get your income taxes withheld or paid correctly, that's exactly what you might end up having to do. But even as the end of November approaches, it's not too late to take action so that you may avoid having to pay these dreaded penalties.
How taxes get out of hand
For most people, the income taxes withheld from their regular paychecks will do. As long as you have enough tax withheld so that you don't owe more than another $1,000 on your tax return, you won't owe a penalty. Furthermore, if your withholding covers 90% or more of your total tax liability, then you won't have to pay penalties even if the amount you still owe exceeds $1,000. Because many people have little or no additional taxable income beyond their paychecks, they don't have to worry about the additional tax on that outside income. For single people or families with only one person who earns income from a job, the withholding tables that employers use to determine how much to take out of paychecks usually are adequate.
And this year, taxpayers who find themselves with a significantly higher tax liability than they had in 2005 may be able to take advantage of another provision to avoid penalties. Even if you don't have enough tax withheld to cover most of your 2006 taxes, you still won't owe penalties if your withholding during 2006 exceeds your total taxes due on your 2005 return. Those who have income of $150,000 or more must pay at least 110% of their 2005 tax liability to qualify for this relief.
However, it can be challenging to tailor your withholding to avoid penalties. Form W-4, which employees complete to determine how much employers should withhold from their paychecks, can be difficult to fill out correctly, especially for those couples who file jointly and both earn income from jobs. Without using the special worksheets provided, it's easy for people not to have enough tax withheld. Furthermore, if you have substantial amounts of outside income that weren't subject to withholding -- including interest, dividends, capital gains, and taxable distributions from retirement accounts -- you may well need to increase your withholding beyond what your employer would otherwise use to avoid penalties.
What you can do
If you realize your withholding isn't going to be enough to avoid penalties, there are a few things you can do. The best way to solve the problem is to make quarterly estimated tax payments throughout the year. If you pay enough estimated tax in equal quarterly installments to meet the guidelines, you usually won't owe any penalties.
However, for most taxpayers, now is too late to start making estimated tax payments. At this point, most people who do that have already made three quarterly payments, with the final one scheduled for Jan. 15. Unless you earn a disproportionately large portion of your overall income in the last three months of the year, making a single estimated payment for the fourth quarter won't help you avoid penalties. But if much of your outside income comes at the end of the year, you may be able to use an alternative called the annualized income installment method to avoid penalties, as long as you pay enough estimated tax by Jan. 15. For instance, many mutual funds, such as the Vanguard International Explorer Fund (FUND:VINEX), expect to make substantial capital gains distributions in December. On the other hand, if you own shares of a fund like Fidelity Magellan (FUND:FMAGX) that made big distributions earlier in the year, this alternative may not work for you.
If it's too late to use estimated tax payments to escape penalties, there may be another way. By increasing the amount withheld from your paycheck, you may be able to add enough to your total withholding for the year to avoid a penalty. Unlike estimated tax payments, money that you have withheld for taxes is treated as being paid equally throughout the year, even if you actually changed withholding amounts during the year. In effect, the increased withholding is like going back and making estimated tax payments in previous quarters.
To increase your withholding, complete a new Form W-4 and give it to the person responsible for payroll. On the form, there is a line that allows you to specify an amount you'd like to add to the amount normally withheld. So if you calculate that you need an extra $1,000 withheld to avoid penalties and you get paid twice each month, you might arrange to have $500 taken out of each of your two December paychecks. When January comes, you can complete another form to change your withholding back to its normal levels.
For some people, paychecks aren't the only way to withhold tax. For instance, if you're taking distributions from an IRA or retirement plan, you can arrange to have tax withheld from these distributions. It's usually possible to change your withholding during the year, so if this is the best way for you to avoid penalties, you should contact your financial institution to get the proper paperwork.
No one likes taxes, but penalties on top of them are just a slap in the face. By looking at your tax situation before the end of the year and taking appropriate action, you can do your best to pay as little as possible to the IRS.
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Fool contributor Dan Caplinger is scrambling to get his year-end tax planning in order. He doesn't own shares of any of the funds mentioned in this article. The Fool's disclosure policy never penalizes you.
