Estimated tax requirements are a standard problem for retirees, as lots of them face penalties in the event that they fail to pay their estimated taxes.
Fortunately, there may be a little-known strategy that might help avoid penalties if a retiree discovers late within the 12 months that estimated tax payments were too low.
Income taxes should be paid prematurely through the 12 months. If not withheld from income, a taxpayer must make estimated tax payments 4 times a 12 months.
The estimated tax payments must be made when the income is earned. You cannot avoid the penalty by making a lump sum estimated tax payment by January 15, 2025, the ultimate payment deadline for 2024.
Just a few years ago, Congress tightened estimated tax requirements, and the IRS invested more resources into identifying and penalizing taxpayers who didn’t meet the necessities.
The result, in line with annual data released by the IRS, is that estimated tax penalties rose 42% from 2012 to 2017 and one other 24% from 2017 to 2022.
Retirees are amongst those more likely to face tax penalties. Most retirees were used to having income taxes withheld from their paychecks during their working years, and it took some time to get used to the estimated tax payments. Additionally, calculating the proper payment amount may be difficult if income fluctuates all year long and from 12 months to 12 months.
Higher rates of interest are another excuse estimated tax penalties have turn out to be more likely. People became accustomed to receiving very low rates of interest on money balances. The increase in rates of interest from 2022 increased the interest income of many retirees and increased their expected tax payments.
If estimated tax payments usually are not made on time or payments usually are not no less than the minimum required amount, a penalty will likely be assessed. The penalty is interest compounded day by day for the time the federal government didn’t have the cash it must have had.
The rate of interest is adjusted quarterly based on government debt rates of interest. Any penalties will likely be applied from the sooner of the payment due date to the due date of the tax return for the 12 months and the date of actual payment.
However, there may be an option you should utilize toward the top of the 12 months when you forgot to make estimated tax payments at the start of the 12 months or if the payments turn into too low.
When taxes are withheld from income, the IRS assumes that the withholding payments will likely be spread evenly all year long, even when there may be a big withholding amount toward the top of the 12 months.
This is where a standard IRA comes into play.
You can claim a distribution from the IRA at the top of the 12 months and request that a portion of it’s withheld for federal income tax purposes. Request sufficient withholding to avoid the estimated tax penalties for the 12 months. (Keep in mind that the distribution itself will likely be taxable and can increase your estimated tax liability for the 12 months.)
But check along with your IRA custodian first.
Some custodians limit the dollar amount or percentage of a distribution that may be withheld for taxes. Or they could require that the distribution and withholding be claimed by a certain date in order that it might be processed by the top of the 12 months.
However, for a lot of retirees, the IRA withholding strategy is a very good method to avoid the penalty for underpaying estimated taxes.
