To Inform:

Congratulations on making it through another tax season! Now you don’t have to worry about paying taxes again until next April, right? Wrong! Believe it or not, the IRS wants their money sooner rather than later (ever wonder why IRA’s have a required minimum distribution?!) and with the looming debt ceiling debate, 2023 will certainly be no exception. So how does the IRS force taxpayers to pay? Simple: penalties. In this issue of Wealthnotes, we’ll discuss two of those penalties: the underpayment of estimated tax penalty and failure to pay penalty, and we’ll also share some strategies for avoiding those.

What is an underpayment? The IRS requires taxpayers to pay at least the lesser of:

1. 90% of their current year tax liability, or
2. 100% of their prior year tax liability (110% if the prior year adjusted gross income is over $150,000) throughout the year.

In order to facilitate payments throughout the year, the IRS has set 4 quarterly dates for calculating any underpayment: April 15^th, June 15^th, October 15^th, and January 15^th. These dates are adjusted slightly for holidays and weekends. To avoid the penalty, one quarter of the annualized required payment must be paid cumulatively by these dates.

How do people pay? There are two primary methods by which individuals pay taxes: 1) withholding or 2) estimated payments. Typical withholding sources include someone’s paycheck, pension, Social Security, or IRA withdrawals. However, some taxpayers have income sources that don’t allow withholding or don’t have enough income to withhold from. Those taxpayers instead choose to pay their taxes quarterly by check (a.k.a. estimated payments).

What is the underpayment of estimated tax penalty? This penalty is effectively an interest charge. If a taxpayer is underpaid for any portion of a quarter, the underpayment is charged an interest rate. The current interest rate for underpayment is 7%! That’s a big change from when rates were only 3% early in 2022.

What is the failure to pay penalty? If a taxpayer is still underpaid at the tax filing deadline, the IRS charges a late payment penalty in addition to the underpayment penalty. The late payment penalty is .5% for each fraction of a month the balance is due, up to a maximum of 25%. This penalty can really add up!

Where do we see opportunities?

Withholding on IRA distributions to avoid estimated payments. The IRS treats any withholding as being done evenly throughout the year no matter when it was withheld whereas estimated payments are treated as being made on a specific date. So, when we think about how the IRS calculates the underpayment penalty each quarter, clearly withholding is a better option. Here is where that is helpful:

• Making estimated payments can be inconvenient and difficult to project as a tax picture changes during the year. For many of our clients that are taking distributions from their IRAs, we are able to work with their accountants to adjust the amount of tax withholding to avoid estimated payments and any penalties.
• Want to avoid taking your required minimum IRA distribution until later in the year? No problem! We can do the entire distribution at the end of the year, withhold all the tax you need, and the tax withholding will be treated as if it was spread evenly over the year.
• If you have a large capital gain or other one-time income event (e.g., bonus or incentive stock award) during the first three quarters of the year, safe withholding can be used to avoid a penalty from early quarters where you may have been otherwise underpaid.

Do you remember the time (before record-low interest rates) when it was bad tax planning to receive a refund in April? You could safely do more with your money than the government. With money market rates in the 4% range that philosophy is back! A well-designed withholding strategy can maximize the interest you earn on your money throughout the year.

• If your 2023 taxable income is significantly higher than your 2022 income, consider paying your required taxes based on your 2022 tax liability. You’ll earn interest on your savings until you owe in April.

Avoiding the late payment penalty. Make sure to do a tax projection and remit your payments by the April due date! Just because you file an extension doesn’t mean you don’t have to pay by that date.

Hopefully this has helped to demystify some of the penalties your accountant may be explaining to you. With good planning, we can not only avoid them, but take advantage of the opportunities they present.

Written by Todd Walter, Partner and Chief Wealth Planning Officer