Withholdings and Estimated Taxes: Avoid A Big Surprise At Tax Time!

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Today’s guest posting comes to us from Alan T. Hostetler, CPA. Alan’s accounting practice, Hostetler Stott, CPA, provides tax preparation and planning for individuals, small businesses, and informational returns for non-profits. 
Visit his website at the following link to find out more! Hostetler Stott, CPA.

Withholdings and Estimated Taxes:  Avoid a big surprise at tax time!
Tax filing season is right around the corner and many taxpayers dread this annual ritual.  Not only can filing a tax return be a tedious administrative chore; it can also lead to an unpleasant surprise if a tax liability is due.  Sending in extra money with your return is always a bummer, but the opposite can be upsetting as well.  If you end up with a large refund you may be wondering why you effectively let the government borrow your money while you struggled with cash flow throughout the year.  The following are some common questions I hear from taxpayers regarding withholdings and payments and some explanation that I hope you will find useful.

My employer takes out my taxes for me so isn’t it their fault if my withholdings are wrong?

Occasionally employers do make mistakes in withholding and it is important that you communicate with them if you feel something was done in error.  However, employees are responsible for providing correct information on their form W-4 Employee’s Withholding Allowance Certificate and the equivalent form for state withholdings when they are hired.  If your address, marital status, or allowance information changes at any time, make sure you inform your employer. Providing fraudulent information (or failing to provide the required information) on your W-4 form may result in penalties of up to $1,000 or imprisonment, so you really don’t want to lie on this form.
 
If you itemize your taxes, it is a good idea to update this form on an annual basis.  Page two of the form W-4 includes a worksheet to more closely figure your withholding amounts for taxpayers who expect to itemize their taxes.  Ask your employer for this form or find it on the IRS website.
If I am self-employed, who takes out my taxes?


Self employed taxpayers, and those who are owners in a partnership usually need to withhold their own taxes and pay them in the form of estimated tax payments.  The IRS provides 4 payment vouchers on form 1040-ES, which you will send in four times per year with payment on a portion of your expected year-end tax liability.  The IRS divides the year up into 4 periods:  1/01-3/31, 4/01-5/31, 6/01-8/31, and 9/01-12/31.   At each of these cutoff dates, you should calculate your estimated taxable net income from your business (and personal income statement) and compute the amount of tax you expect to pay on this income.  15 days after the end of each period, you need to send in your payment to the address in the instructions on the form.  Alternatively, you may make secure payments online on the IRS’s EFTPS website (www.eftps.gov).

Why can’t I just wait until year end to pay all my taxes? 


Even if you are extremely disciplined financially and are able to save up enough to pay your taxes at the end of the year, you should pay throughout the year because you will otherwise likely end up paying penalties on top of your taxes.  The previous paragraph described how to calculate your estimated taxes.  If you do not make adequate estimated tax payments each period, you will be penalized at an annual rate of 4% of the amount you underpaid each period, prorated for the number of days you underpaid your estimated tax payment. 
How can we make sure that we pay in enough to cover our taxes and avoid a penalty?


It is nearly impossible to predict your exact yearend tax liability before year end.  Not only can your income and deduction expectations change, but the tax laws affecting your liability may not be fully determined until after year end!  In 2010, we are still waiting to hear from Congress whether or not certain tax deductions will continue.  With all this uncertainty, we can expect to miss the mark a little, but by making careful projections and understanding the rules for tax payments we can avoid big surprises come tax time. 
There is relief for some newly self-employed taxpayers. The penalty for underpayment of estimated taxes can be avoided by ensuring that your total estimated payments plus any withholdings for the tax year exceed the lower of:

  • 90% of your current year tax minus credits
  • 100% of your prior year tax minus credits (for those making more than $150,000, or $75,000 if married filing separately, this figure increases to 110% of your prior year tax minus credits)
In other words, plan to pay in at least the amount of tax you paid the prior year (10% more if you have high income) and you won’t need to worry about the penalty.  Just be sure you have enough saved up to cover the additional taxes if you have an exceptionally profitable year!

Where can I find more information on estimated taxes and withholdings?

The IRS makes all of their forms, instructions, and publications available online at www.irs.gov.  Here are a few useful links to information on this topic:
2010 Form W-4 and instructions: http://www.irs.ustreas.gov/pub/irs-pdf/fw4.pdf
2010 form 1040-ES and instructions: http://www.irs.gov/pub/irs-pdf/f1040es.pdf
EFTPS online federal tax payments: https://www.eftps.gov/eftps/
IRS Publication 505 “Tax Withholding and Estimated Tax”: http://www.irs.gov/publications/p505/index.html

How about you all? Have you ever had any big surprises around tax time? If so, how did you handle them? What is the most difficult aspect of tax filing in your opinion? 


Share your experiences by commenting below!

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Comments

  1. There are some calculators that could compute for your taxes, although if you’re a business owner, getting an accountant is a far better option.

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