LOISELLE, GOODWIN & HINDS
CERTIFIED PUBLIC ACCOUNTANTS

Estimated Tax Underpayment Penalty and How to Avoid It

It's not a major disaster if you wind up owing Uncle Sam some money when you file your return - after all, you'd rather have the use of the funds for as long as possible. But what you want to avoid is having to pay the IRS a penalty for underpaying your taxes during the year. If you owe the estimated tax underpayment penalty, you're in effect paying the IRS interest for part of the money you should have prepaid during the year for taxes, but didn't.

Fortunately, two important law changes that went into effect this year make it easier to avoid the estimated tax underpayment penalty.

Safe harbor #1. The estimated tax underpayment penalty doesn't apply at all if the amount you owe when you file your 1998 return is less than $1,000. (This threshold used to be $500.) For example, suppose your tax bill for 1998 is $10,000, and you prepay at least $9,001 during the year (in the form of tax withheld from your wages and estimated tax.) The penalty tax doesn't apply because the amount you owe when you file your return is only $999.

Safe harbor #2. If the amount you owe when you file your return comes to $1,000 or more, the estimated tax underpayment penalty won't apply for 1998 if your "required annual payment" - the amount you must prepay during the year in the form of withheld and estimated tax payments - adds up to the smaller of the following two amounts:

1. 90% of your tax bill for 1998, or
2. 100% of your tax bill for 1997 regardless of what your adjusted gross income for 1997 was.

For example, let's suppose your tax bill for 1997 was $12,000 and your tax bill for 1998 will come to $15,000 (90% of that is $13,500). In this case, you must prepay at least $12,000 of your tax bill during 1998 to avoid the underpayment penalty.

Before 1998, the 90% of this year's tax/100% of last year's tax safe harbor applied only if a taxpayer's adjusted gross income for the prior year didn't exceed $150,000 ($75,000 for marrieds filing separately). A tougher rule applied to those whose adjusted gross income exceeded this level (prepayment had to equal at least the smaller of 90% of this year's tax or 110% of the prior year's tax).

It's a pay-as-you-go system. If you will owe $1,000 or more when you file your 1998 return, one-quarter of your required annual payment generally must be paid by April 15, '98, June 15, '98, September 15, '98, and Jan. 15, '99. Keep in mind that tax withheld from your salary is treated as an estimated tax payment, and that an equal part of withheld tax generally is treated as paid on each installment date. That means you may be able to bail out of an estimated tax problem for earlier periods in the year by asking your employer to increase your withholding in later months.

Time for a checkup. You know what your 1997 tax bill came to, but unless you have a reliable crystal ball, you don't know what your 1998 tax will be. We don't have a crystal ball, either, but we can work out a pretty good projection of your 1998 tax based on your financial picture thus far. It may be a good idea for us to get together to make adjustments to your wage withholding and/or estimated tax payments. Keep in mind that our review of your situation may discover that you're withholding too much rather than too little.

(05/07/98)

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Last modified: July 09, 1999