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 can be a problem because if the correct amount of taxes is not withheld, there could be IRS penalties applied when tax returns are filed.
IRS Penalties from Wrong Paycheck Withholding
An individual subject to the estimated tax must pay, on each of four installment dates (normally, April 15, June 15, September 15 and January 15 of the following year for a calendar-year taxpayer), 25% of the “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, taxpayers whose 2013 AGI was over $150,000 must pay the lesser of 110% of the tax shown on the 2013 return or 90% of their 2014 tax liability.
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 salary (and certain other payments) don’t total at least 25% of the required annual payment.
What happens with Underpayment of Estimated Taxes?
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). But a possible solution is increased withholding.
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. Thus, if an employee asks his employer to withhold 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.
Retroactive Payments of Estimated Tax
Other amounts may also be treated as retroactive payments of estimated tax. The same rules described above in regard to amounts withheld from wages and salaries also apply to overpayments of Social Security taxes and to income taxes withheld from:
- supplemental unemployment compensation benefits, sick pay, pensions, annuities and other deferred income (e.g., 20% withholding on certain “eligible rollover distributions” from qualified retirement plans and other deferred income arrangements). A taxpayer who has underpaid estimated tax should consider taking an eligible rollover distribution from a qualified plan before the end of 2014. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2014. The taxpayer 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 2014, but the withheld tax will be applied pro rata over the full tax year to reduce previous underpayments of estimated tax.
- interest and dividends subject to backup withholding.
- gambling winnings.