Employee Education and Communication: How Much Taxes to Pay, and When to Pay Them - fairmark.com

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Determining
how much estimated tax to pay.

In many cases, the best way to determine the amount of estimated tax to pay is the
easiest: use the prior year safe harbor. But sometimes this approach means overpaying. The
best choice then may be to work out an estimate of the current year's tax
liability.

Prior year safe harbor

The same "prior year safe harbor" you use to determine whether you
have to pay estimated tax (see Who
Must Pay) can be used to determine how much you have to pay.

Example:
Your total tax for 2008 was $37,000. Your withholding and credits for 2009
will be
$21,000, so you can't rely on the prior year safe harbor to avoid paying estimated tax.
But you can use the prior year safe harbor to determine how much to pay: $16,000, or
$4,000 per quarter.

The majority of people who pay estimated tax rely on the prior year safe harbor. It has
some major advantages over actually estimating the current year's tax:

• It's
  easy. You don't have to track down a lot of numbers or do any
  complicated calculations if you use this method. All you need to know is the total tax
  from the prior year and the amount of withholding and other credits you'll have this year.


• No
  guesswork. Perhaps it's an exaggeration to say there's no
  guesswork in using this method, because your withholding or credits could turn out
  differently than you expect. But when you base your estimated tax on the prior year's tax,
  instead of 90% of the current year's tax, you're starting from a much firmer number.

Some people wonder whether they're permitted to use the prior year safe harbor even if
they know they're going to owe more tax for the current year. The answer is yes.
If you qualify, the prior year safe harbor is a safe way to avoid the penalty for
underpayment or estimated tax, no matter how large the underpayment is or how obvious it
was that you would end up having an underpayment.

The prior year safe harbor requires a payment of 110% of
the prior year's tax (not just 100% of the prior year's tax)
if your adjusted gross income for the prior year was over
$150,000 ($75,000 if you are married and filed separately).

There are two situations where you may choose not to use the
prior year safe harbor.

Current year tax will be lower

If you have good reason to believe that 90% of your current year's tax will be
significantly lower than your prior year's tax, you'll pay a lot more than necessary if
you rely on the prior year safe harbor.

Example: Last year you had unusually high income because you exercised nonqualified stock options.
You expect your income to be $80,000 lower this year. If you use the prior year safe
harbor for this year, you'll pay $30,000 more than necessary, so it makes sense to base your
payments on 90% of the current year estimated tax.

You shouldn't worry too much about the possibility that the current year tax will be
slightly
smaller. All that means is that you'll get a small refund when you file your tax return.
But you wouldn't want to overpay by $30,000 because you'll lose the opportunity to earn
interest on that amount while you're waiting for your refund.

Current year tax will be higher

There's nothing necessarily wrong with using the prior year safe harbor when the
current year tax will be higher. As discussed above, you can use this rule even if you're
dead certain that your current year's tax will be a lot higher than the prior year's tax.

But some people aren't comfortable with the notion that they'll owe a
huge tax bill in April. And if anything happens to the money before April 15, and you're
not able to make the payment then, you're in a world of hurt. Some people choose to make Voluntary Payments
so they know they won't get into that situation.

Estimating your tax

Form 1040-ES (the form used to pay estimated tax) comes with a worksheet you can use to
estimate how much tax you'll owe for the current year. There's certainly nothing wrong
with using this worksheet — but most people don't. The reason is that the worksheet
takes you through more detail than may be necessary, but still leaves you with nothing
better than an educated guess about your tax liability. The usual way to estimate taxes is
a somewhat simplified method:

• Look at each number on the prior year's tax
  return and ask yourself if this year's number is likely to be significantly different.
  Ignore differences in wages because there will be a corresponding difference in
  withholding. Use rounded numbers and don't worry about minor changes.


• Add up all the differences to see how much
  larger or smaller your taxable income will be for the current year.


• Apply the tax rates to see how much difference
  this will make in your income tax. (If the difference results from a capital gain, apply
  the capital gain tax rates.) Round the number up or simply tack on an added amount if you
  want to increase your comfort level about avoiding a penalty.

Many people using this method don't bother looking up changes in tax rates,
standard deduction and personal exemptions that result from inflation
adjustments. These changes will decrease your tax slightly, so
that's one way of providing a cushion of extra payments.

Example:
Suppose you estimated your current year's taxable income exactly right, but used the
tax rate
schedules for last year to estimate the tax. You would get a refund, because the inflation adjustments
for the current year result in a lower tax.

If you want to
use the current numbers, they are available in our
Reference
Room.

In some cases it makes sense to take into account changes in the law
other than inflation adjustments that can make a significant difference in your tax
liability.
Tax changes for each year are highlighted in IRS
Publication 553.

The next step

Once you've determined how much you need to pay, you should consider whether to use
estimated tax payments or an increase in withholding to cover this amount. Before we turn
to that question, we'll look at the possibility of making voluntary payments in excess of
the minimum amount required.