The Mid-Year Estimated Tax Update Is Critical for Retirees

Market changes in the last few years cause more retirees to be caught by one of the Stealth Taxes, even retirees who avoided this Stealth Tax for years.

The surprising change in Federal Reserve Board policy in the last few months will cause another wave of retirees to be caught.

Retirees are specific targets of most of the Stealth Taxes. But what I think is the stealthiest of the Stealth Taxes, the penalty for underpaying estimated taxes, doesn’t specifically target retirees, yet snares many of them.

Retirees generally had income taxes withheld from their compensation during the working years. It often takes a while after retiring to become used to making regular estimated tax payments and calculating the correct payments.

IRS data show that as the aging of the Baby Boomers increased the number of retirees, the penalties assessed for underpaying estimated taxes dramatically increased.

Fed policies of the last couple of years caused the penalties to spurt again. After more than a decade of keeping interest rates near zero, the Fed rapidly increased rates beginning in 2022.

Retirees were used to steady interest income from their portfolios. When rates jumped from 1% or less to 5% or more, interest income increased. The higher income was welcome, but many retirees failed to incorporate it in their estimated tax payments.

The result was penalties for underpaying estimated taxes because of the increase in interest income.

Inflation’s resilience in 2024 surprised many. They expected inflation to drop sharply. This was supposed to be followed by the Fed slashing interest rates.

But the Fed won’t reduce interest rates as much as expected during 2024 and might not reduce them at all.

That means people who based their 2024 estimated tax payments on the expectation of lower interest income need to reassess their assumptions.

Retirees who cash in some capital gains in taxable accounts also will be hit with the estimated tax penalty if they didn’t anticipate taking the gains when calculating their estimated tax payments. Investors have had a good run recently in stocks, gold, commodities and other assets. It is a good strategy to cash in some gains and rebalance portfolios, but those gains have to be reflected in estimated tax payments.

Taxes must be prepaid through either withholding or estimated tax payments when you expect to owe more than $1,000 in federal taxes for the year.

Income taxes aren’t withheld on many payments made to retirees unless they request withholding.

When the income payer doesn’t withhold income taxes, taxpayers must prepay federal income taxes in four estimated tax payments. Though four payments are due, they aren’t made quarterly.

The payments are due April 15, June 15, September 15 and January 15 (or the following business day when the due date falls on a holiday or weekend).

For most people, the payments should be equal. You can’t avoid the penalty by making a large payment near year end, unless the income was earned unevenly during the year as I discuss later.

States with income taxes have similar requirements.

The penalty for failing to make full payments by the deadlines is interest compounded daily for the period the government didn’t have the money when it should have.

The interest rate is set quarterly based on treasury debt rates. That’s another reason retirees are being hit with higher penalties. The interest rate on the underpayments increased considerably with market rates over the last two years.

The penalty is charged from the day the payment was due until the earlier of the date the tax return for the year was due or the date the delinquent payment was made.

Income taxes aren’t the only taxes you have to prepay. Any other taxes reported on or with Form 1040 must be prepaid, such as penalties on IRA distributions or other items, payroll taxes on household employees, and the 3.8% net investment income taxes, among others.

The straightforward way to calculate estimated payments is to project your tax bill for the year, divide the total by four, and pay that amount in each installment.

The main goal is to avoid a penalty by paying at least the minimum amount. You also should try to avoid having either a large payment due or a refund when filing your income tax return.

Of course, it’s difficult for many retirees to accurately estimate their income tax bills. For those taxpayers, Congress created three safe harbors for avoiding estimated tax payment penalties. Be sure to qualify for one.

• Prepay at least 90% of the current year’s tax liability;
• Prepay at least 100% of last year’s total tax bill; or
• If you are a “high income taxpayer,” you must prepay at least the lesser of (1) 90% of this year’s tax liability or (2) 110% of last year’s tax liability.

The first two safe harbors don’t apply to high-income taxpayers.

A high-income taxpayer is one whose adjusted gross income on last year’s tax return was over $150,000 ($75,000 for married individuals filing separately). Those numbers aren’t adjusted annually for inflation, so more taxpayers qualify as high income each year.

When income isn’t earned steadily during the year and your estimated tax payments fluctuate, consider the more complicated “annualization method.”

Under the annualization method, you compute estimated taxes separately for each payment period. You want to estimate the taxable income, not the gross income, for the period, which means apportioning exemptions, deductions, losses and other write-offs against the income of each period.

The annualization method also is helpful to taxpayers who had a surprising and substantial increase in income late in the year. The sale of an asset or unexpectedly large mutual fund distributions, among other events, can make earlier estimates of taxable income inaccurate and subject you to the estimated tax payment penalty unless the annualization method is used.

When you are or might be subject to the underpayment of estimated tax penalty, Form 2210 should accompany your income tax return.

The form might show that you met one of the safe harbors and don’t owe penalties. It also is where you show the details of the annualization method.

You can refer to Form 2210 during the year to be sure you’re making the correct estimated tax payments.

Fortunately, for the first year of retirement Form 2210 has a section in which a taxpayer can request the penalty be abated for the year before or after the taxpayer retired or became disabled.

There is another way retirees can avoid the hassle and uncertainty of estimated tax payments and still protect against penalties.

When taxes are withheld from any payments to you, the IRS assumes the taxes were withheld equally throughout the year, even if they weren’t. Employees might avoid the penalty by having employers increase their tax withholding late in the year.

Retirees can ask to have taxes withheld from annuities, IRA distributions and many other types of income. If during the year you realize the estimated tax payments for the year are low, you can request that income taxes be withheld from some of your income payments.

You can have taxes withheld throughout the year. Or late in the year, after realizing estimated tax payments are too low, you can request a large amount be withheld from payments received the rest of the year. For example, some people wait until near year-end to take RMDs or other distributions from their IRAs. They can have a large amount withheld for income taxes.

Before deciding to execute this strategy, check with the payer. Some payers have restrictions on how much they will withhold, the types of payments on which withholding is available, or how often withholding can be changed during the year.

Estimated tax payments are made on Form 1040-ES. But it’s better to use electronic options. The easiest way to make the payments currently is on the IRS website at www.irs.gov/directpay.

More details about computing estimated tax payments and avoiding penalties are available in IRS Publication 505, available free on the IRS website at www.irs.gov.