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
- late payment penalties
- underpayment penalties
In my case, I have two sources of income:
- Regular salary
- Investment income (mostly stock trading with play money)
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):
- 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)
- 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?
Thank you so much for the help!