The end of the year is fast approaching. It’s time to assess how your year was financially.
But, can’t I enjoy the holidays and review my year when I organize materials for my accountant in the new year?
The short answer is ‘no’.
The Reason: The IRS is charging 8% Interest on Underpaid Estimated Taxes
Effective October 1, 2023, the interest rate that the IRS will charge on underpaid estimated taxes increased from 3% to 8%. Like bacon, the cost of everything is going up and not paying your fair share of taxes during the year comes with a cost.
Many people misunderstand the tax code and think they can make it all up in April for whatever they owe for taxes for the prior year. That is not the case. The tax system in the United States is a pay-as-you-go model and income taxes are due as you earn the income. That is why generally most have tax withholdings taken out of their check each payroll period or others pay taxes throughout the year, commonly quarterly estimates.
Who is affected?
People with fluctuating income, self-employment income and taxpayers with bonuses and equity compensation need to know where they stand in terms of income and tax liability. Consultants and those in the gig economy should review their income compared to last year to assess if this was a particularly strong year. Additionally, if you have received higher than usual interest income from saving accounts or dividends or capital gains distributions, your tax liability could be higher than normal.
A general rule of thumb is that you are paying 90% of your taxes through withholdings or through estimated tax payments made quarterly.
Look at your income year-to-date to assess where you stand compared to prior years. If your income is up, you may be at risk of underpayment of taxes. If your income is down and you have made tax estimate payments throughout this year or maintained withholdings with your employer, you are likely not impacted.
If you do not have withholdings taken out or are not calculating and paying estimated taxes quarterly, you likely will be assessed for underpayment of taxes with an 8% interest rate applied to the underpayment. Establish a budget and make changes to ensure this is resolved for the new year.
Recommended Actions to Take
No one likes to pay more than needed. It is important to protect your hard-earned money while ensuring you are paying taxes based on income earned during the year. Paying an 8% interest fee on top of your underpaid taxes takes a chunk of money that you have worked hard to earn.
Review your income YTD and calculate your income through the end of this year. Review what you have paid YTD by looking at your paycheck or totaling your estimated tax payments. Then determine:
- Have you paid at least 90% of this year’s tax bill or 100% of the previous year’s tax bill? If yes, you are unlikely to be affected.
- If you have an adjusted gross income greater than $150,000 or $75,000 for married taxpayers filing separately, have you paid at least 90% of this year’s tax liability or 110% of the previous year’s tax bill? If so, you should be good.
The IRS has a tax-withholdings estimator that you can use to assist you in your assessment.
If your income fluctuates, you should be working with your accountant to review withholdings and/or to review tax liability quarterly.
The next key date is January 16,2024. That is the next due date for estimated taxes. While the focus of income taxes is always on the April date, the reality is that the IRS will be calculating penalties based on what has been paid for the year, including the estimated tax payment in January. In fiscal year 2022, the IRS assessed penalties for underpaying estimated taxes in excess of $1.8 billion.
If you have questions, contact your accountant before year end. Seek professional advice to discuss your specific situation as there are nuances and exceptions to be considered that could affect your specific situation.
At LCW CPAs, we work hard to protect your hard-earned money. If you are a client of ours and have concerns about underpayment of taxes, please contact us.
This article is intended to raise the level of awareness and offer general guidance. This is not intended to be tax advice.