Avoiding Underpayment Penalties
If you wait until the end of the year to pay your taxes, the government will add an underpayment penalty. To avoid this, you need to pay your tax throughout the year. There are 4 payment dates, listed below.
So the government requires that you look into your crystal ball and foretell what your income, deductions and credits will be, calculate your tax even though the laws are constantly changing, and then pay the estimated tax quarterly. (They have a special definition of "quarterly." See below.)
How do you get around this "crystal ball" requirement?
1. The Safe Harbor Exception
This is the loophole most taxpayers use. It's appropriate if your income this year will be at least as much as last year's. On last year's tax return, find your total tax before payments. Pay in at least that much, evenly spread among this year's quarterly tax payment dates, and be penalty-proof even if you owe additional tax at the end of the year. If your income is high, you are required to pay in 110% of last year's tax to take advantage of this loophole. If your income is over $1 million, you cannot use the safe harbor exception for your California taxes. Tax payments made through withholdings from your salary (or from your spouse's salary if you are filing jointly) are treated as being made evenly throughout the year.
For the next exception, we first need to talk about the definition of "quarterly."
When are Estimated Tax Payments Due?
April 15, June 15, September 15, and January 15. If a payment date falls on a holiday or weekend, the due date is the next business day. Notice that these "quarterly" dates are not every 3 months.
2. The Annualized Income Exception
The other alternative for calculating an amount of estimated tax which will protect you from the underpayment penalty is the annualization approach. This is often used when a lot of your income is received at the end of the year.
On each of the payment dates, look at your year-to-date income, deductions, and credits as of the last day of the previous month. For example, the June 15th payment covers January - May. Determine your income, deductions, and credits for those 5 months. Multiply everything by 12/5. Calculate the tax. Multiply by 50% to find the required total minimum estimated tax payment due by June 15th, after subtracting estimated tax payments made earlier in the year.
You can use a different penalty exception for each quarterly tax payment date.
California puts a strange twist on the concept of paying quarterly taxes because the required estimated tax payments are not equal. Instead of 25% per quarter, California uses 30%, 40%, 0%, and 30%. I'm not making this up! At least California recognizes the same exceptions (safe harbor and annualization) as the IRS. At least for incomes under $1 million.
If you have questions / concerns, or would like to enlist the services of an experienced CPA tax accountant, please contact me.
M. Bess Kane, CPA