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Scenarios in Quarterly Estimated Tax Payments

Estimated tax paymentsWhen people learn you’re a CPA, one of the first things they assume is that you “do taxes.” Often, they have a “quick tax question.” If you are a tax practitioner, you know a quick tax question is an oxymoron. It’s nice, however, to be able to translate some of our CPA lingo into easily understood information, both for clients and friends. One issue that stands out to me is: when and why does it makes sense to consider making quarterly estimated tax payments? 

Individual estimated tax payments – a primer

The government likes to get their money on a regular schedule. For most people, that means withholding from a paycheck. But if that’s not your situation, the IRS has estimated tax penalties in place that preclude you from waiting until April 15 every year to pay the balance due. In order not to be subject to those penalties, during the year you must pay at least 100 percent (or 110 percent depending on your level of income) of your previous year’s tax liability OR at least 90 percent of your current year’s tax liability. And unless there is a special circumstance where your income fluctuates during the year, those payments are expected to be paid in quarterly installments. 

If income is expected to increase dramatically, a strategy for cash flow conservation is to pay what’s known as the “safe harbor,” which means paying 100/110 percent (again depending on your level of income) of the prior year’s liability, and then being ready to pay the remaining balance due on April 15. In cases of fluctuating income, one approach is to start the year paying the safe harbor estimated payments, and then for the third or fourth installment evaluate whether the amount should be adjusted up or down. 

Common advice to clients who are planning for estimated tax payments is to set aside a flat percent of revenues in a separate account to help make payments when they’re due. Your clients should schedule a visit with you prior to the end of year to have adequate time for tax planning.

Estimated tax payments to the IRS can be made online, by phone or by mail. Most states also have several options for making payments, so individuals can choose what method works best for their situation.

Here are some scenarios you may encounter with your clients or your acquaintances where making quarterly estimated tax payments should be a topic of discussion:

“I started my own business this year.

This situation raises potential service opportunities and additional questions (bookkeeping, retirement planning, business structure, etc.), and almost certainly means that quarterly estimated tax payments are required. Especially as the business is getting off the ground, it may be necessary to calculate each quarter what the estimated net profit of the business is to determine the amount of the payments.  

“I just started selling LulaRoe/Norwex/Rodan + Fields/fill in the blank to make some extra money.”

This scenario is a little trickier and would again depend on the level of net profit the person expects the business to generate. If the individual is doing this work in addition to their regular job, they can also consider adjusting their withholding to account for the additional income. Taking a look each quarter and making an estimated tax payment will help avoid surprises the following April. 

“I inherited an investment account from my mom.”

In this case, the determination would depend on the investment income that the account will generate. Another good opportunity that exists in this scenario is to add value by considering the tax implications of the investments. The Personal Financial Planning Section has an entire page dedicated to tax aware investing strategies and how to create tax alpha.

 “My husband and I both work, we have some investment income, and every year we owe a lot with our tax return.”

In this situation, the best fix is likely to adjust the withholding for one or both spouses rather than making quarterly estimated taxes. If the individual is already claiming zero allowances, then it’s likely he or she will need to specify an additional amount they want withheld from each paycheck. This is a very simple fix made possible by completing and submitting a new IRS Form W-4 and applicable state form(s) to the company human resources specialist.

“I’m retiring this year.”

Yet again another financial planning opportunity for the CPA to reinforce the value of services. Determining whether quarterly estimated tax payments are necessary will depend on the sources of the individual’s income. For example, if a large part of his or her income will now be from retirement distributions, then federal and state withholding will likely be the best and easiest answer. There are a lot of moving parts to discuss related to cash flow needs, required minimum distributions, investment income and many other factors. Check out the CPA’s Guide to Practical Retirement Planning, published by the Personal Financial Planning Section, which contains in-depth technical content to help you walk clients through these complex planning decisions.

As you know, sometimes your client or the person you are talking to at a cocktail party knows the right question to ask. And sometimes you have to be able to determine the real root of their problem and the implications for their holistic financial well-being.

For more guidance on estimated tax payments, see IRS Publication, Tax Withholding and Estimated Tax, and for more information related to penalties that the IRS might assess for various compliance issues, check out this quick reference chart available exclusively to Tax Section members.  

April Walker, Lead Manager--Taxation, Association of International Certified Professional Accountants

 Estimated tax payments courtesy of Shutterstock.

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