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When Late Is Okay

Logan Murray

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:

  • Pay at least 90% of the tax owed for the current year
  • Pay at least 100% of the tax from the prior year, or 110% if you made $150,000-plus in the prior year.

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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