IRS tax penalties: underpayment, late payment, and all that

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mrscatterbrain
Posts: 69
Joined: Tue Nov 03, 2020 1:05 pm

IRS tax penalties: underpayment, late payment, and all that

Post by mrscatterbrain »

Hello Bogleheads,

I am aware that the IRS imposes underpayment and late payment penalties based on how one pays income tax throughout the year, but I'm quite fuzzy on the details. I could use your help in understanding some of the nuances of how these various tax penalties work, and how best to avoid them.

I understand the IRS wants me to pay taxes on income "as I earn it." I also understand they want me to pay my full anticipated tax obligation for the current year (I believe the Safe Harbor rules are either 110% of the prior year's known tax obligation or 90% of the current year's estimated tax obligation, depending on tax bracket). These two logically distinct points of "when" and "how much" tax is paid result in the IRS imposing
  1. late payment penalties
  2. underpayment penalties
to those who do not comply with their rules.

In my case, I have two sources of income:
  1. Regular salary
  2. Investment income (mostly stock trading with play money)
For my salaried income, my employer withholds federal income tax every pay period according to my tax filing status and optional withholdings indicated on my W-4. For income earned through stock trades, no taxes are withheld.

In essence, my questions boil down to whether the IRS treats the "when" and the "how much" conditions of tax payment for each source of income separately. Under what conditions does the IRS issue either the late or underpayment penalties above? Here are a few scenarios to help illustrate my questions (in the following, the total tax obligation is understood to account for both sources of income):
  1. Suppose federal income tax withholdings from my regular paychecks are sufficient to cover my total tax obligation for the current year (ie, investment income from stock trading is negligible this year). In this case, my salaried income has met both the "when" and "how much" criteria from the IRS:
    • I paid tax on my salaried income throughout the year as I earned it
    • The amount of tax I paid fully covered the tax obligation (and possibly overpaid)
    However, the (negligible) investment income does not meet the "when" criteria: I did not pay tax on the investment income throughout the year. My understanding is that in this scenario the IRS will not care about me not having paid tax on my investment income throughout the year, since I have paid my tax obligation via withholdings, and they will not charge a late payment penalty for the investment income. Is this correct?
    • Suppose now my federal income tax withholdings are insufficient to cover my total tax obligation for the current year (ie, I made a lot of extra money trading stocks). In this case, my salaried income still meets the "when" criteria of the IRS (I paid throughout the year), but not the "how much." Now, the IRS does care about "when" taxes are paid on my investment income (having paid tax on my salaried income throughout the year is no longer sufficient). My understanding is that in this scenario, I would need to increase my tax withholdings with my employer and/or make quarterly estimated tax payments to account for the additional investment income (and in particular, if I choose to make estimated tax payments, I must pay them every quarter!). Is this correct? What would happen if I still fail to meet the safe harbor rules (eg, additional withholdings and estimated tax payments are insufficient, due to sudden large gains at the end of the year)?
      • Finally, suppose investments and stock trading are my only sources of income (I'm now an extremely lucky and successful day trader). In this scenario, I do not have an employer who withholds federal income tax for me throughout the year. In this case, my understanding is that I would be required to make quarterly estimated tax payments. However, estimated income and tax obligation in a given year based on a day trading job seem highly uncertain to me. You could be unlucky all year and suddenly have a big win (or loss) in Q3 or Q4. How would estimated tax payments work in this scenario?
      In sum, my impression is that the IRS wants me to pay enough tax regularly throughout the year on my biggest source of income--whichever source is large enough to cover my tax obligation. They do not necessarily care "when" and "how much" tax I pay on each source of income individually. Is this a correct way of understanding at these penalties?

      Thank you so much for the help!
      nalor511
      Posts: 5058
      Joined: Mon Jul 27, 2015 1:00 am

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by nalor511 »

      Download last year's tax software, plot in any scenario you want regarding income, payments, and timing, and see what comes out. This is the best way to learn about these things and make decisions in your personal situation
      User avatar
      gobel
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      Joined: Mon Feb 08, 2021 3:50 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by gobel »

      Even better is to then look at the Form 2210 and worksheets which pop out (or do them by hand) to understand what happened. You will see that first the safe harbor amount is calculated. Then it is divided into 4 equal parts. Then your total withholding for the year is divided into 4 equal parts. Then your ES payments are added in per each quarter. If any of the 4 quarters shows an underwithholding, interest is charged on that amount for the number of days until it is made up. If there are overpayments, it flows over to the next quarter (but you don't get interest on it).

      This makes it clear that withholdings are counted as if they are paid evenly over the year, but 1040-ES payments are not. So you could boost your paycheck withholding in the last couple of months and it'll still count as if the total sum was paid evenly. Using this trick, you can sometimes make up a tax shortfall you discover halfway thru the year and avoid any penalties. Estimated tax payments do not work this way. You cannot write a big check in Dec to the IRS and have it count as paid evenly throughout the year.

      If you have income that comes in lumpy and you made lumpy ES payments, then you can override the default even distribution by filling in Schedule AI to see if that'll help avoid any interest.
      Outer Marker
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      Joined: Sun Mar 08, 2009 8:01 am

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by Outer Marker »

      mrscatterbrain wrote: Fri Jun 18, 2021 11:25 pm In sum, my impression is that the IRS wants me to pay enough tax regularly throughout the year on my biggest source of income--whichever source is large enough to cover my tax obligation. They do not necessarily care "when" and "how much" tax I pay on each source of income individually. Is this a correct way of understanding at these penalties?
      They do care "when" -- you should be paying your taxes at least quarterly on your investment income. However, W2 income counts for the entire year, regardless of when it is received. So, if you make an error and under-pay in Q1 on your investments, you can have your employer withhold extra in Q4 and make it up to avoid penalty.

      Why not make it simple on yourself, and just have the brokerage withhold estimated tax from the gains on your investments when you make the trade? Then, you don't have to worry about penalty, and you don't have to send in quartely estimated taxes.

      If you mess it up and wind up with a penalty, the IRS has a "first time penalty abatement" which you can request by letter if you're assessed a penalty. You have to be current on all taxes and a clean record for the last three years to qualify.
      lstone19
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      Joined: Fri Nov 03, 2017 3:33 pm
      Location: Nevada

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by lstone19 »

      mrscatterbrain wrote: Fri Jun 18, 2021 11:25 pm In sum, my impression is that the IRS wants me to pay enough tax regularly throughout the year on my biggest source of income--whichever source is large enough to cover my tax obligation. They do not necessarily care "when" and "how much" tax I pay on each source of income individually. Is this a correct way of understanding at these penalties?
      The IRS does not care about individual sources of income nor are tax payments tied to particular sources of income. Only total income and total payments matter. Timing of income and timing of withholding can be considered at your option if it's to your advantage to do so.

      I would not say "the IRS wants me to pay enough tax regularly throughout the year on my biggest source of income", rather "the IRS wants me to pay enough tax regularly throughout the year on my income" (notice I removed "my biggest source of"). Payments by withholding are assumed to be equally distributed across the year unless you choose to use actual date of withholding. Estimated payments are credited as of their actual date of payment.
      Topic Author
      mrscatterbrain
      Posts: 69
      Joined: Tue Nov 03, 2020 1:05 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by mrscatterbrain »

      Outer Marker wrote: Sat Jun 19, 2021 8:24 am Why not make it simple on yourself, and just have the brokerage withhold estimated tax from the gains on your investments when you make the trade? Then, you don't have to worry about penalty, and you don't have to send in quartely estimated taxes.

      If you mess it up and wind up with a penalty, the IRS has a "first time penalty abatement" which you can request by letter if you're assessed a penalty. You have to be current on all taxes and a clean record for the last three years to qualify.
      I have never seen this as an option in my taxable brokerage account when I place a trade. How do I do this?
      Outer Marker
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      Joined: Sun Mar 08, 2009 8:01 am

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by Outer Marker »

      mrscatterbrain wrote: Sat Jun 19, 2021 8:35 am
      Outer Marker wrote: Sat Jun 19, 2021 8:24 am Why not make it simple on yourself, and just have the brokerage withhold estimated tax from the gains on your investments when you make the trade? Then, you don't have to worry about penalty, and you don't have to send in quartely estimated taxes.

      If you mess it up and wind up with a penalty, the IRS has a "first time penalty abatement" which you can request by letter if you're assessed a penalty. You have to be current on all taxes and a clean record for the last three years to qualify.
      I have never seen this as an option in my taxable brokerage account when I place a trade. How do I do this?
      Sorry. I may have been mistaken. I trade extremely infrequently in taxable. I always have tax withheld from my brokerage distributions, but that's coming out of an inherited IRA. Guess you have to keep track yourself and make quarterly payments.
      MarkNYC
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      Joined: Mon May 05, 2008 7:58 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by MarkNYC »

      Outer Marker wrote: Sat Jun 19, 2021 8:24 am
      They do care "when" -- you should be paying your taxes at least quarterly on your investment income. However, W2 income counts for the entire year, regardless of when it is received. So, if you make an error and under-pay in Q1 on your investments, you can have your employer withhold extra in Q4 and make it up to avoid penalty. ...

      If you mess it up and wind up with a penalty, the IRS has a "first time penalty abatement" which you can request by letter if you're assessed a penalty. You have to be current on all taxes and a clean record for the last three years to qualify.
      The "first time penalty abatement" policy of the IRS applies only to certain types of penalties, and the penalty for underpayment of estimated tax is not one of them.
      chemocean
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      Joined: Mon Dec 19, 2016 8:45 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by chemocean »

      Does only W2 withholding count as withholding versus estimated payments?
      I am considering using 100% withholding of redeemed I-bonds to pay for Roth conversions.
      Does this withholding count as withholding, thus I could redeem the I-bonds in Dec and not be penalized for underpayment during the year?
      ivgrivchuck
      Posts: 1672
      Joined: Sun Sep 27, 2020 6:20 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by ivgrivchuck »

      If you meet the safe harbor rule via withholding from your salary, there won't be a penalty, no matter when the withholding took place. This is what I do.

      If you make estimated payments throughout the year, then it can get tricky...
      25% VTI | 25% VXUS | 12.5% AVUV | 10% AVDV | 2.5% VWO | 25% BND/SCHR/SCHP
      lstone19
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      Joined: Fri Nov 03, 2017 3:33 pm
      Location: Nevada

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by lstone19 »

      chemocean wrote: Sat Jun 19, 2021 2:10 pm Does only W2 withholding count as withholding versus estimated payments?
      I am considering using 100% withholding of redeemed I-bonds to pay for Roth conversions.
      Does this withholding count as withholding, thus I could redeem the I-bonds in Dec and not be penalized for underpayment during the year?
      Any withholding from a payment to you (salary, IRA distributions, or anything else) is withholding. Only direct payments such as a check or ACH initiated via EFTPS is an estimated payment where the specific date of payment is used.
      tj
      Posts: 9366
      Joined: Wed Dec 23, 2009 11:10 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by tj »

      Just pay the penalty. Unless you are realizing substantial capital gains (and why would you do that?), is it really worth your time

      Or just eyeball it and pay estimated taxes and if you end up with a small penalty who cares?

      You should know how much of your investment sales are gains or losses pretty easily by loooking at your brokerage account.
      chemocean
      Posts: 1573
      Joined: Mon Dec 19, 2016 8:45 pm

      Re: IRS tax penalties: underpayment, late payment, and all that

      Post by chemocean »

      lstone19 wrote: Sat Jun 19, 2021 7:37 pm
      chemocean wrote: Sat Jun 19, 2021 2:10 pm Does only W2 withholding count as withholding versus estimated payments?
      I am considering using 100% withholding of redeemed I-bonds to pay for Roth conversions.
      Does this withholding count as withholding, thus I could redeem the I-bonds in Dec and not be penalized for underpayment during the year?
      Any withholding from a payment to you (salary, IRA distributions, or anything else) is withholding. Only direct payments such as a check or ACH initiated via EFTPS is an estimated payment where the specific date of payment is used.
      To the OP, according to lstone, any withholding is assumed to be spread out during the year.
      So, if you are getting investment income in December, you can request 100% federal tax withholding of this income and it will count for safe harbor for the year.
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