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If you're one of those lucky employees who is enjoying stock options that your employer has awarded you, or if you just pocketed a pile of dividends on your investments, you may need to pay estimated taxes on your profits. Why? Two words: underpayment penalties.
If you make so much on your investments that you figure you will owe at least $1,000 in taxes above the withholding or quarterly estimates you already make, you will, with some exceptions, need to pay those estimated taxes to avoid getting hit with underpayment penalties. The $1,000 gap you must stay within to avoid penalty is between tax and withholding.
You should send the IRS these extra payments for every quarter in which your profits from the sale of stock, dividends, or other capital gains grow so high that they will result in at least a $1,000 increase in your taxes.
Is There Any Way to Avoid the Underpayment Penalty?
Yes, if you are already paying estimated taxes this year (through withholding and estimated tax payments), an amount that is at least as much as:
- 100% of last year's tax liability (if your adjusted gross income from two years ago was $150,000 or less), or
- 110% of last year's tax liability (if your adjusted gross income from two years ago was more than $150,000)
In that case, you won't be hit with underpayment penalties regardless of how much you make in 2004. (Other exceptions are available, but they're fairly specialized and don't apply to most people.) Also, if you're married and will be filing separate returns for 2004, substitute $75,000 for $150,000 in the above sentences.
Another way to avoid penalties: make sure you cover 90% of the tax liability you end up with for 2004 instead. This requires careful planning throughout the year to ensure that you end up at that 90% point on April 15th.
What If I Am Not Paying That Much in Withholding or Estimated Taxes?
If you know that you won't be paying that much in either your withholding or your regular estimated tax payments, you definitely need to plan to make (or increase) an estimated tax payment. You should do so for each quarter in which your profits have swollen so much that you owe at least $1,000 more in taxes.
Of course, the amount you should send depends on the tax bracket you anticipate being in for the tax year. Remember that you need to make payments on a pay-as-you-go basis to avoid underpayment penalties.
Example
If by the second quarter of the year your profits for the year have increased your taxes by $1,000 over your previously estimated payments, you need to cover the extra payment in the second quarter.
How Do I Pay?
Send your payment with Form 1040-ES by the due date listed on the form. You can have this form filled out using tax return preparation software such as TurboTax, or your professional tax advisor can supply the form and compute the amount you need to send.
Your first estimated tax payment is due by April 15th. You may pay the entire year's estimated tax at that time, or you may pay your estimated tax in four payments. The four payments are due April 15th, June 15th, September 15th, and January 17th (of the following year). You may have to pay a penalty if you do not pay enough tax through withholding or estimated tax payments, or if you fail to make required estimated tax payments by the due dates.
Other Options
If you don't want to make these extra estimated payments, you may be able to avoid the penalty by having your employer withhold more taxes from your W-2 wages, from now on.
Caution: this may not be as easy as it sounds. You need to complete Form W-4 and submit it to your employer as soon as you can to have more money withheld from your paycheck. Decrease the number of allowances you claim on your Form W-4; fill out the worksheet on the Form W-4 itself to determine the number of allowances.
Here's the catch: your withholding, added together with any other payments you have made, either through estimates or payments applied from the year before, must total at least:
90% of this year's tax liability, or
100% of last year's tax liability, or
If your Adjusted Gross Income is over $150,000, 110% of last year's tax liability
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