20 Apr How can I avoid underpaying taxes?
Q. For the last 10 years I have always received a tax refund. I have already taken large capital gains this year, 2018, when I sold a good portion of my mutual funds. They didn’t withhold taxes when I sold the funds this year. What can I do to avoid paying interest and a penalty next year when the IRS tells me that I have been underpaying my taxes?
A. There are a couple of items to consider here.
First, you didn’t say if you’re employed and regularly have income taxes withheld from your paycheck or if you pay estimated taxes on a quarterly basis.
If you currently pay your taxes through a payroll deduction and you believe you are going to owe significant taxes at year end due to the capital gain you mention, you are required to pay the additional taxes with an estimated tax payment on IRS Form 1040-ES, said Steven Gallo, a certified public accountant and personal financial specialist with U.S. Financial Services in Fairfield.
Remember this is an estimate and as long as you have paid in 90 percent of the taxes you owe by Jan. 15, 2019 or owe less than $1,000, you will not be penalized, Gallo said.
There is another IRS rule that would allow you to avoid an underpayment penalty, and because you’ve always have gotten a refund, this may apply to you.
“The rule requires your 2018 withholdings be as much or greater than your 2017 tax liability, if so you cannot be penalized no matter how much you owe at the end of 2018,” he said.
For example: Let’s assume for 2017 you had a total federal tax liability of $5,000 and your 2017 withholding was $5,500, giving you a $500 refund. Now assume your withholding for 2018 is exactly the same, $5,500, however your tax liability for 2018 is $7,000 due to your capital gain. Even though you will owe $1,500 for 2018 you will not be penalized because your withholding of $5,500 is greater than your 2017 tax liability of $5,000 — provided you make your full payment by the April 15 filing deadline.
But of course we have a warning.
Due to the 2018 tax law changes, if you are having your taxes withheld by an employer, the amount withheld may have been reduced from the 2017 levels, Gallo said, so you must be careful that you will have enough withholdings to cover your 2017 tax liability.
If you have been making estimated payments all along you, just need to make sure your 2018 estimates are equal to your 2017 tax liability, Gallo said.
“There is sound financial basis for holding on to your money as long as possible before paying your tax bill as long as it can be done without interest or penalty,” he said.
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