Year-end Planning: How Increased Withholding May Avoid Estimated Tax Penalty for Some Taxpayers

October 26, 2012

Some individuals with substantial income in addition to salaries may find that the amount of tax withheld from their salaries isn't enough to cover their required estimated tax payments. This may be the result of miscalculation, or forgotten surprises, for example, a windfall on the sale of a capital asset earlier this year. An individual subject to the estimated tax must pay, on each of four installment dates (April 15, June 15, September 15 and January 15 of the following year for a calendar-year taxpayer), 25% of his “required annual payment” for the current year. The required annual payment generally is the lesser of 100% of the tax shown on the taxpayer's return for the preceding year or 90% of his tax for the current year. However, in figuring 2012 estimated taxes, taxpayers whose 2011 AGI was over $150,000 have to pay the lesser of 110% of the tax shown on the 2011 return or 90% of their 2012 tax liability. (Code Sec. 6654)

The applicable test is applied separately to each installment. Thus, a taxpayer may be penalized for the underpayment of estimated taxes for any installment for which his estimated tax payments plus taxes withheld from his salary don't total at least 25% of his required annual payment.

An individual who has underpaid an estimated tax installment can't avoid the penalty by increasing his estimated tax payment for a later period (although payment in a later period will reduce the period for which the penalty applies).

Increased withholding is one possible solution. Income tax withheld by an employer from an employee's wages or salary is treated as paid in equal amounts on each of the four installment due dates unless the individual establishes the dates on which the amounts were actually withheld. (Code Sec. 6654(g)(1)) Thus, if an employee asks his employer to withhold sufficient additional amounts for the rest of the year, the penalty can be retroactively eliminated. This is because the heavy year-end withholding will be treated as paid equally over the four installment due dates.

RIA illustration: Jane expects her 2012 tax liability to be $15,000. Her 2011 return showed a liability of $14,000. Her withholding for 2012 will total only $10,500 and she has made no estimated tax payments. If she makes an additional estimated tax payment of $3,000 on January 15, 2013, she will avoid any underpayment penalty for the last installment ($10,500 plus $3,000 equals $13,500, which is 90% of $15,000) but she may still be penalized for underpaying the first three installments. But if Jane instead has her employer withhold an additional $3,000 before the end of 2012, her total withholding ($13,500) will be treated as estimated tax payments of $3,375 on each of the installment due dates. Since $3,375 is 25% of $13,500 (90% of $15,000), the underpayment penalty is completely avoided for all four installments.

Outside-the-box solution. An individual can take an eligible rollover distribution from a qualified retirement plan before the end of 2012 if he is facing a penalty for underpayment of estimated tax and the increased withholding option is unavailable or won't sufficiently address the problem. Income tax will be withheld from the distribution at a 20% rate and will be applied toward the taxes owed for 2012. He can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2012, but the withheld tax will be applied pro rata over the full 2012 tax year to reduce previous underpayments of estimated tax. 

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