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Avoid an Unexpected Tax Bill by Planning Now

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For new retirees, the self-employed, and those who realized sizable gains during the year, the possible tax bill that may be faced next April could come as a shock. Being proactive now and implementing year-end tax planning strategies could help investors avoid writing a big check to the IRS next year for additional taxes or underpayment penalties.

Underpayment penalties are usually experienced when taxpayers didn’t withhold enough taxes from the income they received. Common triggers are the following:

  • New retirees not withholding enough tax (or any) from their retirement accounts or failing to pay quarterly taxes when needed.
  • Individuals who sell investment positions, such as stock or real estate, and don’t make an estimated tax payment.
  • Self-employed individuals who get behind or underestimate their quarterly tax payments.

There are general rules for avoiding an underpayment penalty:

  • Owe less than $1,000 for the current year
  • Pay 90% of the current year’s tax owed
  • Pay 100% of the amount of the prior year’s taxes in the current year
  • Or, pay 110% of the prior year’s tax amount if the taxpayer’s adjusted gross income is more than $150,000 in the current year.

If you take some time now to do a quick projection for 2014 and find that you didn’t have enough withheld throughout the year, the following strategies can help you catch up. Unlike estimated quarterly payments, which need to be made by a certain date, income that can be withheld is counted as paid equally throughout the year, even if it was withheld on December 31. With this in mind, consider these two strategies:

  1. If you have wage income, increase your withholding for the end of the year. Even if you currently claim “0” allowances on your W-4, you can file a new W-4 with your employer and have an additional amount withheld from each paycheck. Just remember to switch it back once we enter the new year.
  2. If you have IRAs or Roth IRAs, you can take a distribution for the amount you want withheld and ask for 100% withholding from the IRA custodian. Even if you’re under 59 ½, this can still be a viable option. If funds are available for the tax payment, you may make the IRA distribution and withhold 100% for taxes. Then, you immediately put the same amount back into the IRA as a 60-day rollover. Remember that only one 60-day rollover is allowed per year and that a recent tax court decision has made it so that the once-per-year rule applies to the taxpayer in aggregate, not each individual IRA.

Tax planning takes very individualized considerations, as many conditions or “general rules” may or may not apply to your specific situation. Make sure to consult with your Certified Financial Planner™ professional or your tax advisor to see if a strategy will work for you.

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