This may occur when you receive significant amounts of “unearned” income – income from alimony payments received, investment income (which includes interest, dividends and capital gains income), income realized on the exercise and sale of stock options, net income realized on the sale of your principal residence, and/or net income realized on rental properties that you own – during the year.
The solution is to make timely Estimated Tax Payments
Income from alimony payments received and interest and dividends income tend to be spread uniformly throughout the year. The best approach for such income streams is to make quarterly estimated tax payments, as discussed in the Alimony and Investment Income sidebars.
Income from capital gains, the exercise and sale of stock options, and net income realized on the sale of your principal residence tend to be one-time events. The best approach is to make quarterly Estimated Tax Payments in the quarter in which this income was received.
Not enough Federal income tax was withheld from your salary or wages during the year. Here are a couple of examples:
- You accepted a new job offer in 2018. At that time, you filled out a Form W-4, and gave it to your Human Resources representative. Three performance reviews and one promotion later, you are now earning 70% more than when you first joined the company. While this additional income is well deserved, it also drove you up two Federal income tax brackets. However, the amount of Federal income tax being withheld from your paychecks remained at the level you first set back in 2018.
- You received equity compensation of $100,000 in the form or Restricted Stock Units (RSUs) from your employer. The default Federal income tax withholding rate on RSU income is 22% - or $22,000 - that would be withheld from such income. Normally, your employer would have withheld a portion of the RSU shares awarded to you in order to cover this Federal income tax obligation.That’s fine … if you’re in the 22% tax bracket. However, what if you’re in the 37% tax bracket? Some $37,000 should have been withheld instead. This represents a shortfall of $15,000 or 40.5% (= $15,000 / $37,000) of Federal income tax that should have been withheld from your RSU income, given your AGI.
To determine whether you were inadvertently under-withholding Federal income tax from your paychecks, all you have to do is perform a pair of simple calculations:
- First, calculate your Federal Effective Tax Rate (“ETR”) from your Form 1040 return for the year in question by dividing the “Total Tax” by your AGI, from your 2020 Form 1040 or Form 1040-SR tax return, divide the amount on p.2, line 22 by the amount of p.1, line 11.
- Second, for each of the Form W-2s that you received divide the amount of Federal income tax withheld from your compensation (Box 2) by the amount of Salary, wages and compensation received (Box 1).
- Compare your ETR percentage with the W-2 withholding percentages that you’ve calculated. If the differences are small, there’s nothing that you need to do at this point.However, if the difference is large (i.e., more than a few percent), you should prepare a new Form W-4 to request that additional Federal income tax be withheld from your paychecks, and submit it to your Human Resources representative.
You won’t notice that much of a difference in your take-home pay. And you will no longer receive the unpleasant surprise of a huge Federal income tax bill when your income tax returns are prepared each year.
This may occur when you receive significant net income from self-employment, but either make insufficient estimated tax payments, or worse, don’t make any estimated tax payments on such self-employment income at all.
Let’s be fair: no one relishes the idea of having to make estimated tax payments. However, if you don’t make timely quarterly Estimated Tax Payments to the IRS or to State tax authorities, you may be assessed with various nonpayment and underpayment penalties, as well as interest on the income tax that you owe. These penalties and the related interest may add up to several hundred dollars per authority. I would much rather see you spend these amounts on yourself, your family and children, or on your favorite non-profit charitable organizations that give it to government agencies that will simply squander it away.
Since 2008, the Federal Reserve has pursued a fiscal policy of suppressing the interest rates that banks pay on funds deposited in order to bolster the U.S. economy. Under such fiscal policy, it will be less costly to make Federal and/or State quarterly estimated tax payments on time, rather than wait until the following April to settle one’s income tax liabilities