How to Avoid the Stealthiest of the Stealth Taxes

The estimated tax payment requirement and the penalty for failing to meet it are among the Stealth Taxes imposed on retirees, and they’re becoming more onerous.

A few years back, Congress tightened the requirements for estimated taxes, and the IRS put more resources into identifying and penalizing taxpayers who didn’t meet the requirements.

The result, according to annual data released by the IRS, is that estimated tax penalties increased 42% from 2012 through 2017 and rose another 24% from 2017 through 2022.

Retirees are among those likely to be hit with estimated tax penalties. Most retirees were used to having income taxes withheld from their paychecks during the working years and take a while to adapt to making estimated tax payments four times a year. Also, calculating the correct payment amount can be difficult when income fluctuates during the year and from year to year.

More retirees are likely to be hit with underpayment penalties this year and next year because interest rates have increased so much since 2021. Financial accounts that paid insignificant amounts of interest now are earning meaningful interest. Also, many investors moved money out of both low-interest accounts and risky investments into money market funds and other vehicles that pay steady interest at rates of 5% or so.

Other retirees sold stocks and other investments, recognizing substantial capital gains that compounded over recent years.

When income taxes aren’t withheld, taxpayers must prepay their federal income taxes in four estimated tax payments. The payments are due on April 15, June 15, Sept. 15 and Jan. 15 (or the following business day when the due date falls on a holiday or weekend). Notice that while four payments are due, they aren’t quarterly payments. That’s one reason people can miss a deadline or two during the year.

The tax due for the year is supposed to be spread evenly over the four payments. You can’t avoid penalties by making a large lump sum estimated tax payment near the end of the year, unless the income was earned unevenly during the year as I discuss later in this article.

States with income taxes have the same or similar requirements.

When estimated tax payments aren’t made by the deadlines or the payments aren’t at least the minimum required, a penalty is imposed. The penalty 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. Any penalty is charged from the day the payment was due until the earlier date the tax return for the year was due and the date the payment was made.

Retirees receive investment income from their taxable accounts: interest, dividends, capital gains, mutual fund distributions and perhaps others. There’s no automatic tax withholding on these payments. Retirees also receive traditional IRA and 401(k) distributions and perhaps annuity and pension payments. There’s no withholding on these, unless the retiree requests it. The same goes for Social Security benefits.

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

Income taxes aren’t the only taxes you have to prepay. Any other taxes reported on or with Form 1040 are included in the prepayment requirement, 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 refund when filing your income tax return.

Of course, it’s difficult for many retirees to accurately determine their income tax bill for the year. 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.

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 with inflation, so more and more taxpayers are classified as high income. The first two safe harbors don’t apply to high-income taxpayers.

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. This can be tricky because you do not want to prepay taxes on gross income. You want to estimate the taxable 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 can increase income enough to make earlier estimates of the year’s 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 can be used to show that you met one of the safe harbors and don’t owe penalties. It also is where you can 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 any estimated tax penalties might be abated. 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 might be able to avoid the hassle and uncertainty of estimated tax payments and still avoid 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 have taxes withheld from annuities, IRA distributions or other income. If during the year you realize the estimated tax payments for the year are low, you can request some of your payors to withhold income taxes for payments made the rest of the year.

You can have the payments withheld throughout the year. Or late in the year when you realize estimated tax payments have been too low, you can request a large amount of withholding from payments received the rest of the year. Some people wait until near yearend to take their IRA RMDs or other distributions and have a large part withheld for income taxes.

Before deciding to execute this strategy, check with the payer. Some payors 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 generally 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 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 irs.gov.