Last Minute Tax Strategies to Help Avoid IRS Penalties

Michelle Barron |
Categories

With most of us anxiously counting down the days until we can put 2020 in the rear-view mirror, 2021 will be here before you know it. While I appreciate the few weeks of holiday time to take a break and relax from daily life requirements, once the New Year starts, tax documents will start rolling in and the 2020 tax reporting season will be in full swing.

Due to the financial strain caused by the world-wide pandemic, 2020 brought several notable tax exceptions and extensions, including an adjustment to the deadline for the 2020 first quarterly payments. However, a full waiver is not in place. The United States tax system is set up on a “pay as you go” basis, which means that taxpayers are required to pay taxes throughout the year as they are earning income. Individuals can meet their federal tax obligations either by withholding income or making estimated tax payments. Taxpayers who ignore the rules that don’t make timely payments throughout the year may be assessed estimated tax penalties by the IRS. Penalties are accessed based on the amount of unpaid tax and the Federal short-term rate during the first month of the quarter in which taxes were not paid, plus 3%.

For those that anticipate they will owe taxes and potentially penalties, some quick year-end planning can help you save money and reduce the “tip” you may be required to pay your least favorite Uncle Sam. 

Advisors can help you avoid IRS penalties.

Simply helping clients understand and comply with tax payment requirements can offer the chance to prepare rather than react to avoid penalties altogether. While working, most taxpayers automatically withhold taxes from their paychecks, and quarterly payments are not necessary. Paychecks are typically received regularly; regular withholding complies with the pay as you go requirement. Once you are retired, tax liability is often misunderstood, and tax payments aren’t as standard, which creates a potential need for estimated tax payments. Estimated tax payments are generally calculated based on one of three methods.

  1. Most commonly, estimated tax payments are calculated based on last year’s tax liability. If your income is below $150,000, you can calculate payments by dividing 100% of the previous year’s total liability by the four quarters. For taxpayers over $150,000 in annual taxable income, payments are calculated using 110% of your last year’s total tax liability. 
  1. For those with variable income year over year, rather than basing your estimate on last year’s income, you can estimate liability and payments based on an assessment of your current year’s income assumptions. The amount paid must equal 90% of the current year’s liability in equal quarterly payments. If annual income is underestimated, tax payments may be too low, and an Estimated Tax Penalty may result.
  1. For those who earn income unevenly throughout the year, you can make estimated tax payments based on the Annualized Income Installment Method. Estimated payments are calculated based on actual quarterly tax liability. This method is the most time-consuming as it requires manual calculations each quarter.

Pushing the envelope and finding loopholes

Advisors can also help you be creative and utilize loophole strategies to avoid potential shortfalls and penalties for those that take retirement account distributions. Many retirees take retirement account distributions at various periods throughout the year, sometimes only once per year. Withholdings from retirement accounts are not subject to the same throughout the year estimated tax payment requirements. For clients who have accidentally underpaid or even missed estimated tax payments during the year, you can take a retirement account distribution in the amount of your remaining tax liability with 100% of the proceeds withheld for taxes. This last-minute strategy will fulfill your tax obligation and help you avoid penalties.  For those that want to push the loophole to the extreme, within the 60-day rollover window, you could always put the money back into your retirement account—providing that no other rollovers have occurred in the last year. This would allow you to use the non-retirement funds that would have otherwise paid for your tax liability and avoid taxes due on the distribution itself. 

Ultimately, tax laws are complicated. Understanding the requirements and the various opportunities available for leveraging flexibility can be downright confusing. Advisors can help explain your requirements.  If you are tired of making estimated payments and can take retirement account distributions, a little bit of planning can simplify things for you. If you missed estimated payments or underestimated liability and you have the potential for penalties, some last-minute planning can save you money.  In the end, we would all like to simplify our finances and avoid any unnecessary payments to the IRS.  Let us help you.

This material is provided as a courtesy and for educational purposes only. Advisory Services Network, LLC does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation.