Did Your Withholdings and Estimated Tax Payments Equal Your Tax Due? Should It?

For people with just one or two W2s and perhaps a daycare deduction, getting the amount of tax paid into the IRS to come out correctly is easy enough and can be done within a 95% accuracy rate. The IRS gives the follow instruction:

All taxpayers should review their federal withholding each year to make sure they’re not having too little or too much tax withheld. Doing this now can help protect against facing an unexpected tax bill or penalty next filing season. The sooner taxpayers check their withholding, the easier it is to get the right amount of tax withheld. Taxpayers whose employers withhold federal income tax from their paycheck can use the IRS Tax Withholding Estimator to help decide if they should make a change to their withholding. This online tool guides users through the process of checking their withholding to help determine the right amount to withhold for their personal situation. Taxpayers can check with their employer to update their withholding or submit a new Form W-4, Employee’s Withholding Certificate.

For people with more complex fillings, like the self-employed and investors, it can be more difficult, but there are some blue sky rules about paying estimates based on last year’s tax that can help keep the penalties away. From a “tax planning” perspective, the goal is to examine the ROI of the use of the tax due over a period of time and the risk of loss of capital or risk of performance.  Example:  If a business owner thinks he is going to owe between $10,000 and $15,000 in tax, but is not sure of the exact amount as he has not completed the company books, and last year paid $10,000 in taxes, then the IRS would advise that they should send in $11,000 before April 15th to avoid underpayment penalties. They will still charge interest on any tax that is still unpaid after the deadline, just not a penalty.

To avoid interest the IRS would advise, “when in doubt simply overpay to be sure.” If you think you are going to possibly owe $15,000 and you send in $18,000, then when you file there will be no penalty or interest and you will of course be paid a refund of the over-payment when calculated. However, for the business owner or entrepreneur, allowing the IRS to use your capital “for free” may come with a cost, so it needs to be at least put into the equation by the tax planner. If the $18,000 would buy additional spring inventory that represents a 50% profit and the business reliably sells through 100% in good years and bad, then that $18,000 could represent a return of an additional $9,000 of gross profit, and even minus the hard costs in distribution, perhaps $6,000. So the question is, will the IRS penalty equal $6,000 for underpaying $15,000 for five months. The answer generally is no, not even close.

The IRS is a business, so if you are also a business, a stock trader, or any other kind of non W-2 wage earner, these calculations become just another business decision. If your tax preparer does not have these kinds of conversations with you, then you need to find a new one.