Managing Money
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Decoding the Underpayment of Estimated Tax Penalty Part II s discussed last month, the U.S. has a pay-as-you-go tax system, and unless taxes are paid as income is earned, taxpayers will face an underpayment penalty.
In some cases, taxpayers will need to make estimated tax payments to ensure they satisfy the pay-as-you-go rules. While estimated tax payments are generally required to be made in equal quarterly installments, taxpayers who generate one-time taxable events, such as a Roth conversion, may find it necessary to file using the annual income installment method to reduce or avoid an underpayment penalty. The regular installment method simply takes the total required estimated tax payment for the year and divides it by four to calculate the four equal quarterly estimated tax payments. This default method follows the IRS’ assumption that all income is earned equally over each quarter of the year, requiring estimated taxes to be paid in equal quarterly installments as well. Unlike tax withholding, which is assumed to be paid in equal installments throughout the year (regardless of when it’s actually withheld), estimated tax payments are credited in the quarter when paid. This means taxpayers may be hit with the underpayment penalty if an estimated payment is missed— even if they made up the missed payment in a later quarter. Rather than simply assuming income is earned evenly each quarter, the annual income installment method is a pay-asyou-go tax method that allows a taxpayer to calculate the required 44
NARFE MAGAZINE JUNE/JULY 2021
IN SOME CASES, TAXPAYERS WILL NEED TO MAKE ESTIMATED TAX PAYMENTS TO ENSURE THEY SATISFY THE PAY-ASYOU-GO RULES. quarterly estimated tax payment based on actual income earned during the quarter. Taxpayers may choose to use the annual income installment method when they file their tax return as well. Depending on the circumstances, this may be necessary to reduce or eliminate the underpayment penalty when the safe harbor exception based on 100 percent (or 110 percent if income was greater than $150,000) of the prior year’s tax liability or 90 percent of the current year’s tax liability does not eliminate the penalty.
For instance, taxpayers who trigger an unplanned taxable event later in the year (such as realizing a large capital gain or executing a Roth conversion), may find that they owe a penalty even if they made an estimated tax payment to cover the tax on the income event. Take, for example, a retired couple who in 2019 had an adjusted gross income (AGI) of $150,000, which consisted of pension and Social Security income and resulted in a federal tax liability of about $18,500. Given their consistent income, they have $18,000 withheld from their income in 2020, which is more than enough to satisfy the 90 percent of current year tax liability to avoid any underpayment penalty. Late in 2020, however, they decided to convert $200,000 from the TSP to a Roth IRA, and as a result, their 2020 tax liability jumped to $65,583. Knowing they needed to pay their tax as they earned their income, they made an estimated tax payment on January 15, 2021, of $47,000 to cover the additional tax related to the conversion. To their surprise, however, they discovered that they still owed an underpayment penalty when they prepared their tax return a couple of months later. Due to the increased income and taxes, the minimum amount they needed to have withheld to avoid the penalty was $20,350, which is 110 percent of the
