Managing Money

Decoding the Underpayment of Estimated Tax Penalty Part II

As 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

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

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previous year’s tax liability. Despite paying a total of $65,000 ($18,000 in tax withholding plus the $47,000 estimated payment), the regular installment method required the estimated tax payment of $2,350 (the difference between the safe harbor amount and their withholding) to be paid in equal quarter payments. As a result, they would be assessed an underpayment penalty for not making an estimated tax payment in quarters one, two and three.

Instead of using the regular installment method, they filed their return using the annual income installment method, which allowed them to allocate the $200,000 conversion as fourth quarter income and align it with their fourth quarter estimated tax payment to avoid the underpayment penalty.

This is a simple example to illustrate when the annual income installment method may help, but filing under the annual installment method can be complicated. For additional information, check out the instructions for IRS Form 2210 as well as the actual Form 2210, which is used to calculate estimated tax payments with the annual income installment method.

MARK A. KEEN, CFP®, IS PARTNER, KEEN & POCOCK, AND AN INVESTMENT ADVISER REPRESENTATIVE AND REGISTERED PRINCIPAL OF THE STRATEGIC FINANCIAL ALLIANCE INC. (SFA). SECURITIES AND ADVISORY SERVICES ARE OFFERED THROUGH SFA.

TAX PAYMENT DATE CORRECTION

The May Managing Money column listed erroneous dates for the quarterly estimated tax payment due dates for 2021. The correct dates are April 15, 2021; June 15, 2021; September 15, 2021; and January 18, 2022. NARFE regrets the error.

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