Here at Go Curry Cracker we talk a lot about paying zero taxes. It’s a fun little game that you win just by playing.
But it won’t happen every year, probably. And in the years you owe tax, come April the IRS will penalize you and charge back interest if you haven’t paid enough in advance – either through paycheck withholding or estimated taxes (or both.)
This is how you avoid that bit of unpleasantness.
Avoid Tax Penalties
Tax penalties are applied whenever you fail to pay enough taxes along the way / as the income is earned. For W2 workers, this happens through your employer. For self-employed people, we pay estimated taxes quarterly – both income taxes and self-employment taxes.
Underpayment usually happens from:
W2 employee under-withholding – either you miscalculate exemptions on a W4 or inappropriately claim to be “Exempt”
Self-employed – fail to make appropriate quarterly estimated tax payments. Be sure to include SE taxes (use our SE tax calculator.)
Travel hacker extraordinaire – sometimes people intentionally withhold too little on their W2 job and then make estimated tax payments on the side in order to meet credit card minimum spend requirements. Don’t forget. (I used to do this which is how we we got a free honeymoon in Hawaii.)
Substantial investment income – any of the above but neglecting to include dividend and capital gain income
Safe Harbor Rules
Pay enough tax throughout the year and you will never encounter a tax penalty. But how much is enough?
The IRS provides some safe harbor rules to make this crystal clear:
Rule 1 – pay at least 100% of the tax you owed last year
(or if AGI is more than $150,000 MFJ, pay 110% of what you paid last year.)
For example, in 2020 we paid $4,891 in combined taxes (income and self-employment.) As long as we pay at least $4,891 in estimated taxes this year, we will be fine. Or if AGI is expected to exceed $150k, pay an extra $500.
Rule 2 – pay at least 90% of what you will owe this year
Maybe last year was a big income year and this year you earned much less. In that case, base estimated taxes / withholding on current year income.
Our tax calculator can help with making an estimate. (Designed for tax hackers and early retirees!)
Rule 3 – Be within $1,000 of your total tax burden
If total tax burden for the year is estimated to be $1,001, pay at least $1 up front.
In all cases, you then true up when you file your tax return in April.
Estimated Taxes
As with all things from the IRS, there are rules for estimated taxes. They need to be paid on time and on schedule.
Estimated taxes are due “quarterly” – April 15th, June 15th, September 15th, and January 15th of the following year.
(One of these quarters is 4 months and another is 2, which makes perfect sense…)
If income is lumpy you can calculate as you go, attributing tax to the respective quarter the income was earned. Or you can just estimate for the entire year and pay an equal amount 4 times.
You can use Form 1040-ES (pdf) to make the appropriate estimation.
You can pay by check via mail. You can pay electronically. You can pay by credit card. Details.
I almost always pay by credit card even though it comes with a small fee. As a small business owner, paying my self-employment taxes this way is a deductible expense. And since I’m typically doing this with new credit cards, I’m ok paying $50 in fees to get $500+ in future travel.
Hot tip – you can also apply last year’s refund to this year’s estimated taxes, which could be in lieu of the April payment.
An example of avoiding tax penalties
You make $50k/year as a W2 employee and have your withholding dialed in perfectly.
Then you sell a bunch of stock, realizing a capital gain of $250,000 because you want to buy a house or a sweet boat. Per our tax calculator, for MFJ in 2021 this will result in tax on investment income of ~$36,500 (+NIIT, ignored for simplicity.)
Do you need to do anything?
Clearly the expected withholding from the paycheck will NOT get us to within $1,000 of taxes due for the year.
Do we need to then pay estimated taxes?
Since total AGI will be over $150k, we need to insure we have pre-paid at least 110% of what was owed last year. On the same income in 2020 that would be $2,629 in tax. 110% of that is $2,892.
Option A – make an estimate tax payment of $300 and set aside $36,500 to pay in April.
Option B – increase paycheck withholding by $300 for rest of year and set aside $36,500.
Option C – make an estimated tax payment of $36,500 this quarter because it is convenient to do so
Option D – do nothing
If we do nothing then we are liable for interest and penalties.
Interest is typically the federal short-term interest rate (currently 0%) plus 3%. Today that total is 3%.
Penalties can be harsh – 0.5% per month or partial month, from the date it is due until the date it is paid in full. If our hypothetical tax sale took place in January and we filed in April, that is 16 months of interest (8%.)
Since we don’t meet any of the safe harbor requirements, we are looking at paying another ~10% of the $36,500 tax due, or $4k+/-.
Summary
It is pretty easy to avoid tax penalties for underpayment of taxes. Just follow the safe harbor rules and pay quarterly.
If you have a big income windfall, make an estimated tax payment. This works even if you are W2.
If you are going to pay taxes, be sure to get a free-ish vacation out of it.
Wow, thanks for this. Had no idea the penalties could be so harsh.
For those who were W2’d their careers, it’s important to keep track of this once you RE.
Am I correct in assuming that if you paid zero taxes last year that you automatically safe harbor?
110% of 0 is still zero, right?
Yes, math checks out
Dear Mike,
You do have a professional tax preparer, right?
Just ask them to run 1 or 2 estimates of upcoming tax year income (same or high or low) when you do the current year’s work.
All computerized tax programs can spit this out in 10-15 minutes, just be teeaking a few variables.
They do appreciate your business, right?
To increase paycheck withholding would you just call someone and update your w-4 at work? Would you ever want go the withholding route though? It sounds like making the estimated payment yourself would always be the easiest/most flexible option.
As always thanks for these articles. Getting refreshers on tax issues and getting practical guides like this one really help.
Yes, just file a new W4.
In the example I provided it is probably easiest to just make an estimated tax payment. Maybe you go the W4 route if the side income is more regular.
If you’re not already set up to pay estimated taxes, it can be easier to just update your w4 with the extra amount per paycheck.
Anybody can make an estimated tax payment in a few minutes with a debit card or credit card. No setup required
I recently retired and decided to start doing annual Roth conversions. I did the first one in Jan’21. Should I have sent the associated taxes in in January? Or, can I wait and send them later in the year (without penalty)? I want to avoid penalties, but now fear that I’ll owe some for waiting too long.
Technically the taxes on Q1 income are due in Q1. But… will you owe less than $1,000 next April because you are doing 0% tax rate roth conversions (less than standard deduction) and funding your life from cash, qualified dividends, and long-term capital gains?
Then nothing to worry about. If not, then make an estimated tax payment as soon as convenient. Penalties and interest apply to partial months, so paying 7/31 is better than paying 8/1.
Wait a tick. Under safe harbor rule 1, since our AGI is >$150K (MFJ), if we make an estimated payment to get us to at least 110% of last year’s owed taxes, we should be OK on penalties, right?
Note: I plan to do a “what-if” scenario in TurboTax to verify.
Yes, mostly – because the $ were due in Q1 and you would pay them in Q3, there still may be a (smaller) penalty.
What can be worse than just paying taxes? How about our situation. Both retired but I do a lot of market trading, especially options. For the “privilege” of doing well in my investing during 2020 I got to write a nice high five figure tax payment with our return when we filed this year. Oh, and because our Medicare premiums for 2022 will be calculated on our income from 2020, both our monthly premiums will rise substantially next year, by hundreds of $ each month. A nice scam by our federal government (thankfully I live in a state with no income tax, otherwise that would just be more insult to injury).
Gotta do that stuff in the Roth account like Mr. Thiel
Yeah. I’ll have to figure out a way that I can grant myself millions of shares in an up and coming company, at a fraction of a penny per share. That’s all it will take. And what he did is one of the most egregious ripoffs of shareholders I have seen. But what else is new?
Chuck, you “earned” more money, so you owe more taxes. Where’s the scam?
Sounds like you won a ton of money in the market casino. Why not be grateful that you were so lucky as to “make” money while sitting in front of a computer instead of working? You haven’t been injured, you’ve been fortunate in a year when a lot of people were not.
Lisa, I am retired, on SS as my only incoming revenue, and grow our assets by hard work in the markets. But because I worked hard (it has taken me years to get fairly good at options trading, and a decent amount of my time) my reward is to pay more for the same Medicare we had before. To me that is a scam and just another redistribution of wealth.
1. Safe harbor #3 (within $1000 owed at tax time) is only valid for withholding. It doesn’t apply for estimated tax payments.
2. Safe harbor #2 uses prior year AGI for determining whether you need to pay 100% or 110% of your prior year tax. This makes sense because the idea is to calculate an amount you can pay and not owe penalties regardless of what happens in the current year. So in your example you would not need to do anything to avoid penalties.
3. A minor thing, but are you sure you can deduct fees for paying taxes by credit card? If it was a standalone business then sure, but I assume you have a passthrough business, meaning estimated taxes apply to both personal and business income.
re #3 – on the self-employment taxes, definitely.
Lisa, I am retired, on SS as my only incoming revenue, and grow our assets by hard work in the markets. But because I worked hard (it has taken me years to get fairly good at options trading, and a decent amount of my time) my reward is to pay more for the same Medicare we had before. To me that is a scam and just another redistribution of wealth.
Yeah but I have absolutely no idea of my tax burden. My SE income varies wildly, some months is even negative.
Last years is no basis at all for me. What do i do in these cases?
Pay quarterly based on your actual income for the quarter
Yes, this is the fourth safe harbor rule. You also have the option to pay quarterly based on projecting your current income rate across the rest of the year, instead of estimating anything in the future.
For example, consider someone who operates a seasonal business. If you earn $5K per month regularly but bring in roughly $500K each December alone, you don’t have to prepay based on an estimation. You can pay the June installment based on a projection of $5K per month across the entire year, or $60K overall income. You don’t have to pay taxes on your Q4 windfall until the fourth installment, even if you knew in advance that your income would likely balloon at the end of the year.
For details, see the annualized income installment method on the instructions for form 2210.
If you pay too much as an estimated payment, tax refund, right?!
Yes you get it back.
An example: You think you will owe $0 in tax in April. In February you apply for a new credit card with a $3,000 minimum spend. Then you make one estimated tax payment for $3,000 on that card and immediately file your tax return, which gets you the $3,000 back. Use that to pay off the card. (Important to have some buffer in case the timing doesn’t work out.)
Safe Harbor works great for my business taxes. But with investments it’s confusing.
What if I decide the market is a bubble, sell everything, and have a 500k gain.
Is that covered by my safe harbor payments based on last year’s return? Or do I have to send an estimated payment in to cover that in same quarter I sell?
Your example seems to indicate my pass through business taxes safe harbor will cover this big personal investment gain.
It just seems odd that the IRS would trust the average american to hold onto 36.5k for potentially 15 or 21 months with extensions.
Safe harbor means safe harbor. It’s the IRS so it doesn’t need to make sense :)
It’s 15.5 months max. The taxes are due in April regardless of when you file or how many extensions you get.
Thanks for the info! I appreciate it.
I’m always trying to make the tax code make sense….need to think of it more like a computer program….it’s just a bunch of rules that execute.
Downside: the following year, the safe harbor amount would be HUGE.
Which means you would have to pay in advance enough to cover all potential scenarios (deferral, profit share %, income, investment earnings, etc).
Yes you would have to pay at least 90% of what you would owe this year. If you realize another large capital gain and/or do a large Roth conversion, pay the taxes for it that quarter.
Do I need to pay it quarterly tho or can I make just one payment on Q1 or Q4 for the entire year?
The IRS wants all of their money at least quarterly.
You could pay faster than that if you wanted (e.g. pay 100% of your expected tax for 2023 in January 2023.)