Money Matters

Money Matters: How to avoid getting hit with an underpayment tax penalty

CorrespondentJune 7, 2014 

Q. I’ve been a struggling artist for years and now I’m making more money than I’d ever dreamed of making. I’ve never worried about taxes because I never made enough to even owe taxes. I’ve lived rent free for years with my parents in return for doing odd jobs and running errands for them. These past two years, I owed what to me were a lot of taxes and last year I got hit with an underpayment penalty. This year I am going to make estimated tax payments and it is my understanding that I can avoid any penalties as long as my total payments equal what I owed last year. Is that correct?

A. It is a bit more complicated than just making sure your estimated payments total what you owed last year. If you underpay an estimated tax installment you can’t avoid the underpayment penalty by overpaying in the next installment. Since the required annual payment must be paid in four equal installments to avoid a penalty, determining the amount of estimated tax to pay is important.

The easiest way to determine the amount to pay is to use the prior year safe harbor rule. If you make estimated tax payments in 2014 equal to 100 percent of the tax owed for 2013 you will not be subject to an underpayment penalty. If your adjusted gross income (AGI) is over $150,000 this safe harbor amount is increased to 110 percent of your prior year tax liability. You can use this prior year safe harbor even if you know you are going to owe more tax this year than last.

Another method to avoid an underpayment penalty is to pay estimated tax equal to or above 90 percent of taxes you will owe this tax year. This requires some number crunching and guess work on your part. Unless you think your income for 2014 will be significantly lower than last year I suggest you use the prior year safe harbor amount for your estimated payments.

The underpayment penalty doesn’t apply if tax due is less than $1,000 or you had no tax liability for 2013.

For nearly all taxpayers, the due date for the first estimated tax payment of each year is April 15, the same day the return is due for the previous year. If you owe money with your tax return and have to make an estimated tax payment, you will have two checks to write on or before April 15 (they go to different addresses). The next estimated payments are due June 15th, September 15th and January 15, 2014. If any of the above regular payment dates fall on a weekend or legal holiday you get an extra day or two, until the first day that isn’t a weekend or holiday. This year, the June payment is due on the 16th since the 15th is a Sunday. Most states require estimated tax payments on the same schedule as the federal payments. If you itemize deductions, it may be to your advantage to make your fourth quarter estimated tax payments in December, not January, so you can deduct it a year earlier.

Estimated federal payments are made on Form 1040-ES, Estimated Tax Voucher. This is a very simple form, asking for your name, address, social security number and the amount you are paying. In North Carolina use form NC-40. Get the forms from your tax professional, tax software. You can also get the forms from the IRS by calling 1-800-Tax-Forms or go their web site “ www.usgov.org.” For NC form NC-40, go to the Department of Revenue’s website dornc.com.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624

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