Pay estimated taxes on one-time capital gain event?

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Pay estimated taxes on one-time capital gain event?

Postby phositadc » Mon Jul 26, 2010 7:48 pm

I recently became the owner of a fair amount of individual stocks and have been reallocating them into an equities (mutual funds, etc.) and bond portfolio. I sold about half of the individual stock in May, and am planning to sell the other half in August. I will incur substantial capital gains as a result of these sales (over $100k), but once I complete the sales in August, the money will just be sitting in the mutual funds and bond funds for the next 35+ years, so subsequent capital gains will be minimal.

My question is this: Do I need to pay estimated taxes on these one-time capital gains from the May and August sales of the individual stock?

I see that the first estimated tax payment was due on April 15. I did not have any capital gains at that point, nor did I even know I would be reallocating and incurring capital gains. It seems unfair--or even unconstitutional--to penalize me for missing an "estimated tax" payment on income that I did not even know I would have at the time. But I guess any penalty for a missed payment on June 15 would be fair, since I had incurred some capital gain at that point.

Any advice appreciated!
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Re: Pay estimated taxes on one-time capital gain event?

Postby zblongladder » Mon Jul 26, 2010 8:05 pm

chrikenn wrote:I recently became the owner of a fair amount of individual stocks and have been reallocating them into an equities (mutual funds, etc.) and bond portfolio. I sold about half of the individual stock in May, and am planning to sell the other half in August. I will incur substantial capital gains as a result of these sales (over $100k), but once I complete the sales in August, the money will just be sitting in the mutual funds and bond funds for the next 35+ years, so subsequent capital gains will be minimal.

My question is this: Do I need to pay estimated taxes on these one-time capital gains from the May and August sales of the individual stock?

I see that the first estimated tax payment was due on April 15. I did not have any capital gains at that point, nor did I even know I would be reallocating and incurring capital gains. It seems unfair--or even unconstitutional--to penalize me for missing an "estimated tax" payment on income that I did not even know I would have at the time. But I guess any penalty for a missed payment on June 15 would be fair, since I had incurred some capital gain at that point.

Any advice appreciated!


Do your withholdings & credits add up to as much as your previous year's taxes? (I.e., did you get a refund or break even on your tax return last year?) Per http://www.irs.gov/publications/p505/ch02.html it looks like you don't have to pay estimated taxes if you had 100% of your tax liability withheld the previous year (and that return covered 12 months).
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Postby DSInvestor » Mon Jul 26, 2010 8:06 pm

See IRS Pub 505:
http://www.irs.gov/pub/irs-pdf/p505.pdf

In Chapter 4 - Underpayment Penalty for 2009:
General Rule
In general, you may owe a penalty for 2009 if the total of your withholding and timely estimated tax payments did not equal at least the smaller of:
1. 90% of your 2009 tax, or
2. 100% of your 2008 tax. (Your 2008 tax return must cover a 12-month period.)
Your 2009 tax, for this purpose, is defined under Total tax for 2009 on page 49.

Higher income taxpayers. If your AGI for 2008 was more than $150,000 ($75,000 if your 2009 filing status is married filing a separate return), substitute 110% for 100% in (2) under General Rule on this page. This rule does not apply to farmers or fishermen.


It looks like you'd be able to avoid tax penalties for 2010 if the sum of your tax withholding and estimated payments is 110% of your 2009 tax as a high income taxpayer.
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Postby sscritic » Mon Jul 26, 2010 9:45 pm

When you do file, you can use the annualized method on form 2210 (Underpayment of Estimated Tax by Individuals, Estates, and Trusts). The annualized method often produces lower or no penalties for people with incomes that arrive unevenly during the year. If all your income were in December, you can pay all your estimated tax by the following January 15.

Generally, the payments should be made in four equal amounts to avoid a penalty. However, if you made unequal payments because your income was received unevenly during the year, you may be able to avoid or lower the penalty by annualizing your income.
http://www.irs.gov/taxtopics/tc306.html

Also, the penalty is only on the underpayment of estimated tax. If you can increase your withholding for the rest of the year, the amount of estimated tax required goes down dollar for dollar, which reduces the potential penalty.
The United States income tax is a pay-as-you-go tax, which means that tax must be paid as you earn or receive your income during the year. You can either do this through withholding or by making estimated tax payments. If you do not pay enough tax, you may have to pay a penalty for underpayment of estimated tax.
ibid.

If you look at form 2210, you will see that withholding is applied first. Penalties only apply to the excess tax that was not withheld and for which you did not make sufficient estimated payments.
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Postby Spirit Rider » Mon Jul 26, 2010 11:32 pm

The simplest and most effective method is to use the withholding safe harbor.

1. If this is a one time event and your income not counting this event is similar to last year, this is fairly easy. Just ensure that your withholding this year is at least 100% (110% if AGI > 150K) of your tax liability from last year.

2. Withholding is treated as being equally applied during the year no matter when it is withheld, You can bump up your withholding late in the year to make sure you withhold enough.

3. It doesn't matter how big the one time event is as long as your meet the withholding safe harbor, you can pay all of the taxes for the one time event on April 15th.

P.S. This is especially helpfulfor people with MRDs, who would otherwise need to do estimated taxes. You can have your distributions in december and withhold up to 100% and have that apply during the year in liu of the same amount of estimated taxes.
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Postby sscritic » Tue Jul 27, 2010 12:23 am

Spirit Rider wrote:2. Withholding is treated as being equally applied during the year no matter when it is withheld,

Not quite. Line 19 of form 2210 starts with
19 Estimated tax paid and tax withheld (see page 3 of the instructions).
and then there are four columns for the four payment due dates. You have the option of using the actual withholding dates. Here is what the instructions say (bottom of page 3 and top of page 4)
In column (a), enter the tax payments you made by April 15, 2009; in column (b), enter payments you made after April 15 through June 15, 2009; in column (c), enter payments you made after June 15 through September 15, 2009; and in column (d), enter payments you made after September 15, 2009, through January 15, 2010.

For withheld federal income tax and excess social security or tier 1 railroad retirement tax (RRTA), you are considered to have paid one-fourth of these amounts on each payment due date unless you can show otherwise. ...

If you treat withholding as paid for estimated tax purposes when it was actually withheld, you must check box D in Part II and complete and attach Form 2210 to your return.
http://www.irs.gov/pub/irs-pdf/i2210.pdf

Most people will use the "equally applied" rule, but for some, the penalty might be reduced using the actual dates of the withholding.
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Postby zblongladder » Tue Jul 27, 2010 7:59 am

sscritic wrote:
Spirit Rider wrote:2. Withholding is treated as being equally applied during the year no matter when it is withheld,

Not quite. Line 19 of form 2210 starts with
19 Estimated tax paid and tax withheld (see page 3 of the instructions).
and then there are four columns for the four payment due dates. You have the option of using the actual withholding dates. Here is what the instructions say (bottom of page 3 and top of page 4)
In column (a), enter the tax payments you made by April 15, 2009; in column (b), enter payments you made after April 15 through June 15, 2009; in column (c), enter payments you made after June 15 through September 15, 2009; and in column (d), enter payments you made after September 15, 2009, through January 15, 2010.

For withheld federal income tax and excess social security or tier 1 railroad retirement tax (RRTA), you are considered to have paid one-fourth of these amounts on each payment due date unless you can show otherwise. ...

If you treat withholding as paid for estimated tax purposes when it was actually withheld, you must check box D in Part II and complete and attach Form 2210 to your return.
http://www.irs.gov/pub/irs-pdf/i2210.pdf

Most people will use the "equally applied" rule, but for some, the penalty might be reduced using the actual dates of the withholding.

Nevertheless, you can treat witholding as equally applied, since that seems to be more advantageous to him here.
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Postby sscritic » Tue Jul 27, 2010 9:11 am

zblongladder wrote:Nevertheless, you can treat witholding as equally applied, since that seems to be more advantageous to him here.

He never mentioned when his withholding occurred.

1) If he got a very large bonus check in January with 1/2 his withholding for the whole year, he wants it all to be counted in January before the capital gains and not spread out equally over the year.

2) If he gets 1/2 his withholding in December, he does want it spread out equally during the year (what people who take RMDs in December do - see Spirit Rider's P.S.).

3) If his income is uniform during the year and he adjusts his withholding upwards today, he does want that extra withholding in the last half of the year spread out equally (to move some back to before the capital gains).

He probably should both increase his withholding and make estimated payments to meet one of the safe harbors (and to reduce the payment due on April 15).
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Postby phositadc » Tue Jul 27, 2010 4:54 pm

Thanks to all for the helpful replies. I had looked at those IRS publications but didn't really understand the safe harbors.

Looks like I will be safe from paying penalties so long as I pay at least 110% of my tax liability from last year.

Thanks again, everybody.
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Postby zblongladder » Tue Jul 27, 2010 5:12 pm

sscritic wrote:He probably should both increase his withholding and make estimated payments to meet one of the safe harbors (and to reduce the payment due on April 15).


Why should he pay estimated if he's meeting the safe harbor requirements? It seems like they're tailor-made for his situation, and he shouldn't have to pay anything until April 15. Meeting the safe harbor and paying the estimated taxes is just a waste of time and money.
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Postby zblongladder » Tue Jul 27, 2010 5:25 pm

chrikenn wrote:I had looked at those IRS publications but didn't really understand the safe harbors.


Here's how I understand it:

The IRS would prefer to get your income tax in withholding rather than in a lump sum on April 15 (since, if your withholding is less than what you owe, you've basically gotten an interest-free loan till April 15), so you have to pay 90% of your taxes via withholding or pay a penalty. This is totally fair for situations where somebody's using accounting shenanigans to try to minimize their tax bill, but it's totally not fair in situations like yours. So, for situations like yours, Congress says that if you estimated that your taxes for this year would be like your taxes for last year, that's good enough (you don't have to predict the future, since you made a good-faith attempt to estimate your tax liability). I guess they figure people with $150k or more of income are probably more likely to see big windfalls like this and should have to figure that possibility into their estimates.

Basically--if you're doing well enough on withholding to normally expect a refund, you've probably got nothing to worry about (you might want to adjust the withholding a little higher to make sure you meet the 110%). If you're coming up even or owing the IRS money usually, you'll really need to increase your withholding.
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Postby sscritic » Tue Jul 27, 2010 6:21 pm

zblongladder wrote:Why should he pay estimated if he's meeting the safe harbor requirements? It seems like they're tailor-made for his situation, and he shouldn't have to pay anything until April 15. Meeting the safe harbor and paying the estimated taxes is just a waste of time and money.

Just my personal preference. I would rather have an amortized loan and make regular payments than have an interest only loan with a balloon payment at the end.
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Postby MarkNYC » Tue Jul 27, 2010 8:25 pm

zblongladder wrote:
Meeting the safe harbor and paying the estimated taxes is just a waste of time and money.


With regards to state income taxes, this statement is often untrue, and blindly adhering to it can actually cause an unnecessary waste of money.

Here's an example. Let's say a taxpayer has $120K income in 2009 with the federal and state tax fully covered by withholding, lives in a high-tax state, say California, and itemizes deductions. In the following year, 2010, things are similar except for an additional $50K income not covered by withholding, so the taxpayer's 2010 withholdng provides a "safe harbor" and the additional 2010 tax on the $50K can be paid without penalty in April 2011. Why pay sooner? If the taxpayer is not in AMT in 2010, paying the approximate $4,800 state tax in December 2010 provides an additional 2010 federal deduction, reducing federal taxes by approximately $1,300 (roughly 28%). If the taxpayer waits until April 2011 to pay, and is subject to AMT in 2011, the $4,800 state tax deduction, which is not deductible for AMT, provides no federal tax benefit in 2011 and the benefit of the deduction is permanently lost. This is a simplified example and all relevant facts need to be considered, but this type of error of omission is not that uncommon, can be costly, and usually goes unnoticed.

Even if the taxpayer is out of AMT again in 2011, paying the state tax in December provides the deduction one tax-year sooner and there is a small benefit due to the time value of of the federal tax savings.

This type situation could be more common in 2010 than most other years due to the suspension of 2009 RMD's and their reinstatement in 2010.
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