A.K.A. Estimating & Withholding Income Taxes
Short and to the Point
The federal income tax had a few starts and stops in the 1800s following the Civil War, and it wasn’t until the passage of the 16th Amendment that the foundation for the income tax system we have today was laid.
The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
That’s it! These thirty-one words were the first seeds to the sprawling tax code that is just over 2,650 pages (approximately a million words), or as long as 11,652 pages (over five million words) if you include all the IRS regulations that support Title 26 of the U.S. Code.¹ Even if we leave out the complications of adding in state income tax rules and variations, there is no way to summarize every concept and nuance from the continually-evolving tax code. This post is going to focus on the basic ins and outs that are especially important to understand, as we are in the thick of tax season; but first a little more history.
Calling Their Bluff
During the 1800s, the income tax system experimented with flat taxes as well as a corporate tax. The whole income tax concept was progressive, as prior to this point government taxes were limited primarily to tariffs on domestic and international goods. The first American income tax was signed into law in 1861 but was repealed in 1872 as political appetites changed. There were ongoing questions about the ability of Congress to pass laws that allowed this new source of revenue.
In 1895, the federal income tax was deemed unconstitutional by the Supreme Court in a 5-4 decision on the case of Pollock v. Farmers’ Loan & Trust Company because income taxes are “direct” taxes. The method by which income tax was implemented was thrown into disarray because direct taxes must be divided among the states according to population.²
It would take another two decades to have this rectified, and it came about through an unlikely challenge. In an effort to kill the concept of the income tax for good, politicians proposed a constitutional amendment because they believed this “amendment would never receive ratification by three-fourths of the states. Much to their surprise, the amendment was ratified by one state legislature after another,” thus nullifying the earlier Supreme Court ruling.³
Putting it into Practice
The 16th Amendment made it crystal clear that Congress has the authority to tax any income without the restrictions created in the Pollock Supreme Court case. What that means at the most basic level is that every taxpayer’s income is measured, and a tax is applied. What that means in practice is that every taxpayer needs to take aim and hit a moving target. Just how to do that can vary depending on how you set up your cash flow.
For retirees with a consistent year-to-year income, an easy route to stay compliant with today’s income tax system at the federal and state levels is to have your tax payments withheld directly from the payer. Pension payments, IRA distributions, and even employer-sponsored retirement plans like 401(k) and 403(b) plans will allow (and sometimes require) income tax withholding. When you make the request to have funds withheld, the payer will send part of your distribution to you (the “net” amount) and the tax payment portion to the appropriate tax authority. It is the responsibility of the taxpayer to calculate their annual tax liability and then instruct the payer as to the desired withholding amounts.
For example, if you estimate your federal income tax liability to be $6,000, you could choose to have $500 per month withheld. This would leave you with no refund and no amount due come April 15th.
For pre-retirees and retirees with incomes that vary throughout the year, landing perfectly with no refund and no amount owed takes more planning and work. It’s more likely that a taxpayer will overpay (and receive a refund) or underpay (and owe taxes). There’s no bonus to overpayment – it is like a 0 percent loan to the government. On the other hand, underpayment creates a problem: penalties and interest charges. These penalties and interest can apply even if you estimate your taxes correctly for the year.
For example, if you received all of your income in January and you pay your expected tax liability in April a year later, you can expect an underpayment problem.
What should you do if you have inconsistent income? Look to the tools you have available, like quarterly estimated tax payments, and exceptions to the underpayment rule, like safe harbor.
Quarterly estimated payments are used to help taxpayers stay on track throughout the year. The IRS divides the year into four periods, and each period has a due date for when the quarterly estimated tax payment is due:
- For income made January 1st through March 31st
Send the quarterly estimated payment by April 15th - For income made April 1st through May 31st
Send the quarterly estimated payment by June 15th - For income made June 1st through August 31st
Send the quarterly estimated payment by September 15th - For income made September 1st to December 31st
Send the quarterly estimated payment by January 15th of the following year
Safe harbor is different and can take shape in a few ways. The easiest way to qualify for safe harbor treatment (which means there are no underpayment penalties or interest owed each year) is to send in quarterly payments or use withholding to pay:
- 90 percent of the tax you owe for the year, or
- 100 percent of the previous year’s tax liability
The rule is tweaked a little bit if you have higher incomes ($150,000+ for couples or $75,000+ for individuals or married filing separately):
- 90 percent of the tax you owe for the year, or
- 110 percent of the previous year’s tax liability
Making sense of all the nuances, exceptions, and uncertainties takes practice and a deep understanding of the tax code. Repeating the estimating and withholding process annually can help most people stay on track, but some taxpayers will need additional help due to the complexity of their portfolio and non-recurring payments. Do not rely solely on your tax preparer or accountant to get this done; it is just as important that your investment advisor coordinates with your retirement income tax plan to keep more money in your pocket. Contact us for a complimentary review of your portfolio to look for complex items or potential tax headaches down the road.
Doug “Buddy” Amis, CFP®
