The decision about making appropriate estimated payments for tax return liabilities has presented challenges in prior years. The Tax Cuts and Jobs Act has added new difficulties, and additional analyses are required to ensure the appropriate amount of estimated taxes is paid for the current year.
The new tax law adjusted the rate for taxes that are withheld from paychecks. Many analysts are sounding an alarm that more taxpayers may find they have a tax payment due next year, since a review of withholding was not made early in the year to assure the amount being withheld is sufficient to cover taxes. There is also a possibility that taxpayers may be over-withholding taxes. If you haven’t reviewed the withholdings on your W-4 (Employee Withholding Allowance Certificate), you should take a look at it to ensure that your employer is using the proper number of personal allowances when computing your withholdings. The IRS website provides a calculator to review your withholding taxes.
It is important not to be under-withheld in order to avoid a penalty for paying required tax payments late. It is also imperative not to be over-withheld, as it is taking longer to receive refunds from the IRS and states, especially if they are large. Due to continued problems with identity theft, the IRS is also verifying
the identity of the person who has a large refund to determine that the tax return is valid. This may slow up the refund for an even longer time.
Many people have income from sources other than wages which require them to make estimated payments towards their current year taxes in order to avoid underpayment penalties. To determine these estimated tax payments, you need to consider wages and withholding. If there is not a prior year tax liability or the expected tax liability is less than $1,000, payments would be due at the time the tax return is due and would not require payments throughout the year.
There are three methods that may be used to compute estimated taxes in the current year to avoid the underpayment penalty on the tax return. The penalty is reviewed on a quarterly basis to determine if the taxpayer is underpaid.
The first method is to pay in 100 percent of prior year taxes (110 percent if income exceeds $150,000 for married individuals). Generally, this method provides a safe harbor. If income is increasing, this method allows the taxpayer to use the prior year tax as an estimate for the current year and pay the remaining balance when the return is due in April.
The second method is to pay 90 percent of the current year tax. If the taxpayer has a situation where income is decreasing, they may want to use this method to avoid having excess payments sitting with the IRS which later will need to be refunded.
The third method is annualization, which may allow taxpayers to make smaller payments throughout the year. It is useful for taxpayers whose income significantly fluctuates throughout the year, with most of the income being realized later in the year. This permits the taxpayer to defer the payments to the government and better match payments to their cash flow.
You should review your estimated federal and state payments and withholding if you expect a significant change in your income for the current year. You should also review payments before year-end to assure that your payments are sufficient to reflect the changes in the new tax law.
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