I EXPECT TO OWE some $8,000 to the IRS on April 15. On the surface, this might seem like poor tax planning. But I’d argue that it’s just the opposite.
Too often, folks are excited to get a large refund when they file their annual tax return. In response, you’ll hear financial advisors jumping in and saying, “That’s bad. You gave the IRS an interest-free loan.”
In theory, I agree. But until recently, savings accounts have been paying so little that it wasn’t worth the effort for folks to manage their tax liability that closely. That’s changed, however, in the current interest rate environment.
Let me explain. With my own tax planning, I’m expecting to owe taxes. It would be a different story if I got this surprise in April or if I was avoiding tax payments because I didn’t have the money. But the fact is, I’m aware of where I stand and I’ve been planning for April’s tax bill throughout 2022.
I’m in the early years of running my own business. My income started low and has been increasing each year. In 2021, my net business income was a four-figure amount, which resulted in a small tax liability. In 2022, I’ll report almost four times as much income as I did last year, resulting in more taxes due.
The IRS is a pay-as-you-go system. If you’re self-employed and have no tax withholding from your income, you’re required to make estimated tax payments each quarter based on the amount of your income. It can be hard for a business to know what its income will be for the year. The IRS understands this, and offers two options to remain compliant with your taxes:
Adhering to one of these two options doesn’t relieve you of any further tax liability, but it does allow you to avoid penalties for the underpayment of taxes as of your tax filing date. Many refer to the above sums as the “safe harbor” amount.
The reason I’ll owe so much money is because I’m following No. 2 above. Since my 2021 tax return had a small tax liability, I based my 2022 estimated tax payments off that number and held on to the rest of my cash. That way, I won’t owe any penalties even though I paid a relatively modest amount of tax throughout the year. But in the meantime, I’ve been collecting some interest on my cash.
This interest was a small win when yields were so low. But in today’s interest rate environment, with savings accounts paying 3%-plus and short-term Treasury bonds yielding well over 4%, overpaying your taxes to ensure a big refund really is an interest-free loan to the IRS. The bottom line: I’m going to owe $8,000 whether I paid it on Jan. 1, 2022, or I pay it on April 15, 2023, so I decided to hold onto that money and earn some interest.
I recognize my situation isn’t common, especially among retirees. Still, retirees can also take advantage of the safe harbor rules. The IRS treats quarterly tax payments differently from tax withholding. Quarterly tax payments are counted on the date of the payment, while withholding is counted as if it was paid ratably throughout the year.
Let’s say you’re retired and need to take required minimum distributions (RMDs) each year. Perhaps you don’t need that money to cover your living costs throughout the year. Meanwhile, you have to make estimated tax payments because of other income, such as the gains in your regular taxable account.
One strategy: You might wait until year-end to take your RMD and, at that juncture, have enough tax withheld to “safe harbor” yourself. The IRS would view this as comparable to making quarterly tax payments throughout the year, even though you didn’t actually make the payment until the end of the year. In the meantime, you got to use the money for the full year to earn extra interest within your retirement account.
Logan Murray is a solo financial advisor. His company Pocket Project offers subscription-based financial planning services to young professionals. For more financial insights, read Logan’s blog, connect with him on LinkedIn and check out his earlier articles.
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I am doing #2 this year as well. I was suprised to hear this was an option. I have a large 2022 tax bill comming due to due to the sale of a residence. As you note, my tax advisor said just to pay what I paid in 2021 in quarterly estimated tax payments. The rule does not make any logical sense to me, but its an allowed option, so might as well take it.
Another benefit of owing a balance: If your identity is stolen, and someone files a fraudulent return in your name and you were expecting a refund, it’s a huge hassle that *you* will be involved in to recover that refund. OTOH, if you owed a balance, it’s mostly the IRS’s problem to recover that fraudulent refund that the IRS paid out, saving you considerable hassle and anxiety.
Good article, Mr Murray. A bogleheads.org thread from two days ago discusses the RMD withholding trick to avoid estimated tax payments as well: https://www.bogleheads.org/forum/viewtopic.php?t=392290
A possible advantage to having a balance due when filing your federal income tax return (and not getting a refund) is avoiding the problem of having to verify your identity with the IRS.
Several years ago I wound up filing a return with a small refund. I got a letter from the IRS indicating my return and refund were on hold until I verified my identity. I learned I was among millions of taxpayers requesting refunds who received ID verification notices that year (pre-Covid). Since I was unable to create an IRS online account without verifying my identity, I had to call the IRS to resolve the matter. I spent hours telephoning the IRS, usually getting a “agents busy-try again later” message after spending more than 5 minutes on each call. Finally managed to get through to an agent and got my identity verified.
My understanding is that returns with refunds are the target of such identity verification screening.
At most brokerage houses, you can have whatever you want withheld from your taxable IRA withdrawals for state and local taxes; at Fidelity, the same thing is true with non-taxable Roth distributions. They count as withholding – you can pay your whole year’s tax from your December withdrawal, and you’re still good.
I prefer to be fully paid up, and I just apply the overage to next year’s tax. The interest I might lose is not high relative to my income, just a few hundred dollars or so.
Good stuff Logan. I have done so for 50 years. While working I used to massviely under withhold for front end of a year and then increase to high levels around August/September to just meet safe harbor requirements. As you point out, withheld tax doesn’t have to match up with income time frame like estimated payments are technically supposed to. I currently volunteer doing taxes with AARP and I inform folks of their oppurtunity cost when they seriously over withhold and get a huge refund. Some appreciate and heed the advice, but a large portion still want to see that big refund in the spring however! For some it is a forced savings and they like the big “surprise” refund. Oh well, to each his own.
Definitely a preference, and many in my experience also enjoy the “bonus” at tax time which is worth forgoing the interest to them. To each their own