Navigating the Maze of Extra Withholding Taxes and Quarterly Tax Payments
How to avoid those nasty IRS underpayment penalties.
Ah, the first time you get slapped with a significant tax underpayment penalty. It's like a rite of passage for us HENRYs, isn't it? One moment, you're toasting to that hefty bonus or the sale of your first successful startup. The next, you're gawking at a tax bill that could make a grown man weep. It's almost comical... almost.
But hey, welcome to the high earners club! Now, let's talk about how to dodge that unpleasant surprise next time. The secret lies in understanding withholding taxes and quarterly payments.
You see, most employees have their taxes neatly withheld from their paychecks. But for us HENRYs, it's not always that simple. We often have bonuses, commissions, capital gains, RSU’s, real estate investments, K1 distributions, and other income that can make our tax situation a bit more... intricate.
Extra Withholding Taxes
These are the taxes your employer deducts from your paycheck. For most employees, withholding taxes cover their tax liability for the year. But for high earners like us, with our bonuses, RSU’s, etc. we might need to withhold a bit more.
So, how do you do that? Well, it's pretty straightforward. You just need to fill out a new W-4 form with your employer and specify the additional amount you want to withhold. It's like telling your employer, "Hey, take a bit more now so I don't have to cry later."
But here's the catch: withholding more means less money in your pocket each paycheck. It's a bit like dieting - you're cutting back now to avoid a bigger problem later. But don't worry, you'll get used to it. And trust me, it's better than the alternative.
Estimated Quarterly Taxes
Now, let's talk about estimated quarterly taxes. These are essentially prepayments of your tax liability. If you're like my friend Alex, a successful software engineer with a penchant for investing in startups, you might have income that's not subject to withholding. In that case, you'll need to make estimated tax payments.
But how do you know if you need to pay estimated quarterly taxes? Well, the IRS has some rules about this. Generally, if you expect to owe more than $1,000 in taxes after subtracting your withholding and refundable credits, you should be making estimated tax payments.
But here's the kicker: paying estimated quarterly taxes means you're essentially giving an interest-free loan to the government. It's a bit like lending money to a friend who never pays you back. But in this case, the friend is Uncle Sam, and the alternative is a penalty.
How much should you pay and when?
When it comes to paying taxes, it's not just about the 'how much,' but also the 'when.' As high earners, we often have income that doesn't fit neatly into the regular paycheck model. Bonuses, capital gains, distributions, and other forms of lumpy income can lead to underpayment of taxes, which can result in penalties. To avoid this, we need to understand the concept of estimated quarterly taxes.
The IRS expects anyone who will owe $1,000 or more on their tax return due to insufficient previous tax payments and withholding to make estimated tax payments. This is particularly relevant if you're self-employed, have realized large capital gains, made taxable withdrawals from retirement accounts, earn high Social Security benefits, have Restricted Stock Units vesting, exercise stock options, or receive other large income payments.
Now, let's talk about the timing. Quarterly taxes aren’t actually due every three months. The first payment is due in April to coincide with the federal tax-filing deadline and the last payment is due after the end of the year. The specific dates are April 15, June 15, September 15, and January 15 of the following year. It's crucial to mark these dates on your calendar to avoid any late payment penalties.
Determining how much to pay can be a bit tricky. You can usually avoid the underpayment penalty if you owe less than $1,000 in tax after subtracting your withholding and refundable credits. You can also avoid it if you paid at least 90% of the taxes you owe for the current year or 100% of the taxes you owed for the prior year. However, these are just guidelines. Your specific situation may require a different approach.
To calculate the exact amount, you can complete the worksheet in IRS Publication 505 or use the IRS’s Form 1040-ES. You'll need to have information available from your previous year’s tax return. If you have self-employment income, remember that your tax liability also includes self-employment tax, which is Social Security and Medicare taxes totaling 15.3% on your income up to a certain level.
Lastly, you have options on how to make these payments. You can fill out the voucher in the IRS Form 1040-ES publication and mail it with a check to the IRS address listed in your state. Alternatively, you can make quarterly payments online. If you or your spouse have income from another job and have taxes withheld, you can have more money withheld from your pay as an employee to help cover the extra income. Or, you may be able to have taxes withheld from other types of income, such as IRA withdrawals, unemployment benefits, or Social Security payments.
Should You Pay Your Quarterly Taxes?
When it comes to managing your taxes, one strategy that some high earners consider is whether to pay estimated quarterly taxes or to hold onto the funds and settle the tax bill at the end of the year. Overpaying your taxes feels like a 0% interest loan to the government, and your money could be put to better use. This decision often boils down to a comparison of the potential earnings from investing the funds versus the cost of underpayment penalties. Let’s walk through a mental model of a potential $30,000 underpayment.
The IRS charges a penalty for underpayment of taxes, which is essentially an interest charge. For 2023, this interest rate is 7% per year, compounded daily. If you underpay by $30,000 for the entire year, you would owe approximately $2,100 in penalties. However, the timing of your income can significantly impact this calculation. If you earn a large portion of your income later in the year, the penalty would be prorated based on the number of days the payment was late.
Now, let's consider the potential returns from investing that $30,000. If you were to put that money in a high-yield savings account offering a 4.5% APR, you would earn around $1,350 in interest by the end of the year. Or if you were to invest in a short-term real estate bridge loan offering a 12% return, you could potentially earn $3,600. However, if you earn a significant portion of your income halfway through the year, your potential investment returns would be lower.
Here are the pros and cons of each approach:
Paying Quarterly Taxes:
- Pros: Avoid underpayment penalties, peace of mind knowing taxes are paid.
- Cons: Missed opportunity to invest the funds and potentially earn a higher return.
Settling at the End of the Year:
- Pros: Potential to earn a higher return if invested wisely, flexibility with your cash flow.
- Cons: Risk of underpayment penalties if your investment return is less than the IRS interest rate, potential stress of a large tax bill at year-end.
In this scenario, if you're confident in your ability to earn a 12% return on a real estate bridge loan, it could potentially be more profitable to invest the $30,000 and pay the tax bill at the end of the year, even after accounting for the underpayment penalty. However, if you're considering the high-yield savings account, the return would be less than the IRS penalty, making it less advantageous.
Whether to pay your quarterly taxes or settle at the end of the year depends on your individual circumstances, your risk tolerance, and your confidence in your investment strategy. It's always a good idea to consult with a tax professional to understand the best approach for your situation.
Wrapping it up!
So, what's a HENRY to do? Well, it's a bit of a balancing act. On one hand, you have the safety and simplicity of extra withholding. On the other, you have the flexibility and potential investment opportunities of paying estimated quarterly taxes.
Personally, I prefer to play it safe and add extra withholding on my W4 form equaling a few extra percent. If I end up with some extra deductions at the end of the year, I use my tax refund to fund my children’s 529 accounts. It might not be the most exciting choice, but it gives me peace of mind. And when it comes to avoiding an IRS audit, I think that's worth its weight in gold.
But hey, that's just me. What about you? How do you handle your taxes? Do you have any tips or strategies to share? Let's continue the conversation in the comments below.