Estimated Tax Underpayment Penalty

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Elbowman
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Estimated Tax Underpayment Penalty

Post by Elbowman » Thu Jun 15, 2017 9:48 am

TLDR; Is the Estimated Tax Underpayment Penalty based off your total federal taxes due or the difference between your federal taxes due and your withholdings?

Hi folks,

I wanted to check my understanding of the Estimated Tax Underpayment Penalty, and would appreciate your help. Last year I had a big difference between my federal taxes and withholdings, but this year I am *fairly* confident my withholdings will be > 90% of my federal taxes (the threshold to avoid the penalty). How confident is *fairly*? Confident enough that I won't bother with Estimated Tax Payments if the penalty is based off the difference between my federal taxes and my withholdings, but maybe not so confident that I would do the same if it is based off my entire federal tax bill.

Rephrased with numbers, if the penalty is 4% (which I read somewhere), and my withholdings are only 89% of my federal tax bill, will my penalty be 0.11 * 0.04 = 0.44% of my federal taxes, or 1.0 * 0.04 = 4% of my federal taxes?

I've read several web pages on this but the language was ambiguous. Thank you so much!

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flamesabers
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Re: Estimated Tax Underpayment Penalty

Post by flamesabers » Thu Jun 15, 2017 10:15 am

I would recommend reviewing form 2210 if you haven't already. It walks you through the process of figuring out if you owe a penalty and if so, how much.

https://www.irs.gov/pub/irs-pdf/f2210.pdf

If you look at lines 14-17, the penalty is based on the difference between what you paid and what you owe, not your total tax liability.

Elbowman
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Re: Estimated Tax Underpayment Penalty

Post by Elbowman » Thu Jun 15, 2017 11:04 am

Thank you flamesabers!

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Bengineer
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Re: Estimated Tax Underpayment Penalty

Post by Bengineer » Thu Jun 15, 2017 11:36 am

I'd recommend running your taxes in December, particularly if you have variable income. That way, you can make a Q4 estimated payment to cover any shortfall you discover.

kaneohe
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Re: Estimated Tax Underpayment Penalty

Post by kaneohe » Thu Jun 15, 2017 1:12 pm

What you owe is the safe harbor: lower of 90% of this yrs taxes or 100 % (or 110% for higher AGI) of last yrs taxes. The penalty (interest) is
based on the shortfall between your payments and the safe harbor and also the timing of your payments. If your payments were equal each period
but you had a shortfall, you would owe 4% interest on each of the 4 payments.........the 1st would be a yr late, the 2nd 9 mos.late, etc so you
end up paying roughly 2.5% of the shortfall.

Afull
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Re: Estimated Tax Underpayment Penalty

Post by Afull » Thu Jun 15, 2017 2:10 pm

Elbowman wrote: Rephrased with numbers, if the penalty is 4% (which I read somewhere), and my withholdings are only 89% of my federal tax bill, will my penalty be 0.11 * 0.04 = 0.44% of my federal taxes, or 1.0 * 0.04 = 4% of my federal taxes?
Note the 4% is an annualized rate. So the penalty is based on the number of days late. For the penalty to be all of 4% the number ofdays late would need to be 365 days. The referenced form takes this into account by quarter.

Using the safe harbor approach and being a little off is not worth worrying about the penalty unless there is a lot of variance in income thru out the year.

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FIREchief
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Re: Estimated Tax Underpayment Penalty

Post by FIREchief » Thu Jun 15, 2017 5:54 pm

Bengineer wrote:I'd recommend running your taxes in December, particularly if you have variable income. That way, you can make a Q4 estimated payment to cover any shortfall you discover.
Also could just increase withholding for last paycheck.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

Elbowman
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Re: Estimated Tax Underpayment Penalty

Post by Elbowman » Thu Jun 15, 2017 8:21 pm

Thanks for the replies everyone!

There is not actually too much variance in my income. Last year I got married and filed jointly, and it turns out there were no withholdings from my wife's fellowship grants (for grad school), which will not happen this year.
kaneohe wrote:What you owe is the safe harbor: lower of 90% of this yrs taxes or 100 % (or 110% for higher AGI) of last yrs taxes. The penalty (interest) is
based on the shortfall between your payments and the safe harbor and also the timing of your payments.
Ah, so it is even less than I thought. Thank you.

So what I gather from your comments is that there is a small chance (I will most likely withhold >= the safe harbor) of paying <= 4% of a few percent (difference between withholdings and 90%) of my federal taxes as a penalty. The back-of-the-envelope Expected Value calculation suggests that number is too low to worry about :D .

Thanks again everyone!

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FIREchief
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Re: Estimated Tax Underpayment Penalty

Post by FIREchief » Thu Jun 15, 2017 9:56 pm

The dollar amount is trivial and really just amounts to paying interest at slightly over what you might pay on your HELOC. The more meaningful concern is just having to deal with the hassle of that non-trivial IRS form to calculate what you owe (there may be an option for them to do the calculation - I forget; I've only filled it out once).
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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dodecahedron
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Re: Estimated Tax Underpayment Penalty

Post by dodecahedron » Fri Jun 16, 2017 8:20 am

FIREchief wrote:The dollar amount is trivial and really just amounts to paying interest at slightly over what you might pay on your HELOC. The more meaningful concern is just having to deal with the hassle of that non-trivial IRS form to calculate what you owe (there may be an option for them to do the calculation - I forget; I've only filled it out once).
Yes, the IRS states in the Form 2210 instructions that you don't need to calculate the penalty. The Service will calculate it for you and send you a bill.

However, if a disproportionate share of your taxable income arrived late in the year, you may be able to use the "annualized installment method" to reduce the applicable penalty. (This could happen either because your deductions were frontloaded or your gross income was backloaded. In either case the IRS would generally not have the information to do this potentially beneficial calculation for you.)

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