Category: tax

Category: math

Generally speaking, you need to pay estimated tax every quarter. If you did not pay enough, then you will pay “estimated tax penalty”, this is what line 79 of form 1040 is for.

Although it is called “penalty”, it is essentially an interest on the late payment. The interest rate for underpayment (and overpayment as well) on each quarter is determined as this: First find the federal short-term rate in the first month of the previous quarter, rounded to the nearest integer, plus 3%. For example, the federal short term rate in October 2017 is 1.27%, so the interest for the first quarter 2018 is ROUND(1.27%) + 3% = 4%. In the same way, we can derive the interest rates for the rest of three quarters of 2018 are 5%. The IRS also publish the updated interest rate directly, the table up to the first quarter 2021 is here.

Since the due dates for each quarter’s estimated payments are 4/15/2018, 6/15/2018, 9/15/2018, 1/15/2019 respectively, and due date for the tax return is 4/15/2019, so the tax payments for each quarter are late for 12, 10, 7, and 3 months respectively. Let us assume the income, estimated tax payment (or withholding) are the same for each quarter, i.e. you owe the same amount each quarter, the weighted average of annual interest rate for 2018 is:

which means you pay about 3% for 2018 on the shortage to required tax payment, which is the lesser of 90% of the current year’s tax or (100%|110%) of last year’s tax (with details below for 100% vs 110%).

Even the penalty is not a huge amount, it is better to avoid it. The penalty will not apply if you satisfy one of the following conditions (see form 2210 and form 2210 instruction):

  • The current year withholding is more than current year tax liability * 90%.
  • The current year withholding is more than current year tax liability - $1,000.
  • The current year withholding is more than last year’s tax liability * X, where X = 110% if the adjusted gross income on your previous year’s return is over $150,000, or over $75,000 if you are married filing separately, otherwise X = 100%. A special case is that you had no tax liability for prior year and you were a U.S. citizen or resident alien for the entire year.

The first two condition is hard to follow as it request to know the current year’s tax which you don’t until you complete the return. On the other hand, all the numbers are known for the third condition: the previous tax year is on the last year’s form 1040, in general we can use line 61 but for special situations, please see form 2210 instruction for details; the withholding is on your pay check stub and can be easily extrapolated to the end of year. If you expect you won’t satisfy the third condition, and are worried about the penalty, you can use form w4 to make a one time additional payment.

The third condition is a sufficient condition, not a necessary condition. That is, if this condition is satisfied, then there will no penalty. For example, a million dollars capital gain without tax paid, you just need to pay the tax owed by the due date without penalty. However, if it is not satisfied, it does not mean the penalty will apply. There will be no penalty still if either of the first two conditions are satisfied which we do not know until we prepare the return for the current year.

The third condition does not work well if you had a million dollars additional income in previous year, but not in current year. It still works, but just not well.

For W-2 employees, by default the income and withholding are considered as earned and paid equally on each quarter, for example, if you paid $400 on 4th quarter, it can be treated as paid $100 each quarter, so you can make up the tax shortage at the end of year.

For estimated payment made on 1040-ES, unfortunately we have to test each quarter. If you owe taxes in previous quarters, you cannot make it up no matter how much you pay in current quarter, so you may end up with a situation where you have a refund, but still owe underpayment penalty.

The states have similar conditions to avoid penalties, for example, you do not pay penalty for VA if you satisfy one of the following conditions:

  • You have paid 90% of the tax you owe, or the tax owed is less than $150, for the current year.
  • You have paid 100% (always 100% regardless of your income) of the tax you owed for the previous tax year.