Minimize your IRS penalties

There are many ways that individuals can be subject to IRS tax penalties. The point of this column is to identify some of these penalties and show you how to minimize them. In 2023, the IRS assessed about $7 billion in tax penalties. The average penalty was $500, which was significantly more than the average penalty in recent previous years.

Many retirees are assessed penalties because they fail to make estimated tax payments that are sufficient. For example, according to Forbes, estimated tax penalties increased by 24% from 2017 through 2022.

Most employees, during their working years, have taxes withheld from their paychecks. After they retire, many find it more difficult to estimate the minimum amount of required estimated tax payments when income varies significantly during retirement.

As a result, when they fail to make sufficient estimated tax payments, they are faced with penalties.

One reason for the spike in penalties a few years ago is that the Federal Reserve raised interest rates beginning in 2022. As a result, many savers made higher interest income, and some failed to prepay enough taxes to cover the unexpected boon. Other retirees get into trouble by selling securities at a gain and failing to prepay the taxable gains.

Another common situation is the retiree who takes a required minimum distribution (RMD) for the first time and does not withhold sufficient taxes. When an individual takes an RMD, regulations do not require that such tax be withheld, and indeed an individual can elect against it.

RMDs increase in size each year because the expected lifetime decreases each year, affecting the computation. And if the assets in the taxable retirement account have grown in value since the previous Dec. 31 balance, that’s another factor that leads to larger RMDs.

Retirees should plan early in the year to avoid the tax deficiency that will result from inadequate estimated taxes or withholding.

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

TIMING OF ESTIMATED PAYMENTS

When the full amount of income taxes is not withheld, taxpayers must prepay federal income taxes in four estimated payments.

The payments are due April 15, June 15, Sept. 15 and Jan. 15. If the due date falls on a holiday or weekend, the following business day can be used.

While the four payments are due, they are not quarterly payments. The tax due for the year is supposed to be spread evenly over the year. Penalties are not avoided by making a large payment at the end of the year, unless the income was earned unevenly during the year. States with income tax have the same or similar requirements.

PENALTIES

When an estimated payment is not made by the deadlines, or the payments are not at least the minimum required, a penalty is assessed. The penalty is interest compounded daily for the period the government did not have the funds when it should have. The interest rate is set quarterly and is based on Treasury debt rates.

The penalty is charged from the date the payment was due until the earlier of the due date of the income tax return or the date the payment was made.

Other taxes that should be prepaid include: penalties on retirement account distributions; payroll taxes on household employees; and the 3.8% net income tax.

To calculate your estimated payment, compute your estimated tax for the year and divide by four. Pay that amount in each of the four installments.

There is a so-called safe harbor to avoid estimated income tax penalties. You can avoid penalties if:

_ You prepay at least 90% of the current year’s tax liability.

_ You prepay at least 100% of last year’s total tax bill.

_ As a "high income" taxpayer (i.e., your adjusted income, or AGI, was over $150,000 or $75,000 for married individuals filing separately), you prepay at least the lesser of 90% of this year’s tax liability or 110% of last year’s tax liability.

See more details in IRS Publication 505, available at the IRS website IRS.gov.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.

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Elliot Raphaelson

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