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Special Delivery: Income Tax Payments to Uncle Sam

S Rossi 2014
Stephen A. Rossi, MBA, CFA®, CFP®, ChFC®
Senior Vice President, Senior Equity Strategist
[email protected]
(585) 419-0670 x50677

Published on July 13, 2021 in the Rochester Business Journal

What can I say – your rich Uncle (Sam) wants a cut of your financial well-being each and every year, and he’s quite serious about collecting His share. When and how he goes about doing so can take many forms, including weekly/bi-weekly payroll withholding, withholding from traditional Individual Retirement Account (IRA) distributions, estimated quarterly income tax payments, and/or a lump sum payment at the end of each year. One way or another, he’ll get what’s coming to him, for how else could we afford to keep this great Country running?

Regular payroll withholdings are perhaps the most common delivery mechanism for the payment of income tax. Typically, an employee fills out a W-4 Form at the onset of their employment, providing some indication of the dependents the employee expects to claim at year-end, whether or not any additional deductions are anticipated, or whether or not the employee desires any extra withholding to be made for tax. Using this information and things like the employee’s base salary and expected bonus for the year, the employer applies a commensurate Federal tax rate to the employee’s earnings and withholds the appropriate amount of tax from each paycheck accordingly. Interestingly, this structure provides great opportunity for payroll processing companies, in that they (on behalf of their corporate clients) collect these withholdings on a weekly or bi-weekly basis, but only remit them to Federal, State and/or local taxing authorities quarterly. As a result, the company earns interest on the “float”, which is the period of time between when taxes are collected to the time that they’re actually paid.

Another common delivery mechanism for the payment of income taxes is through regular withholding from traditional IRA distributions. Under the current law, if an individual turns seventy and a half subsequent to 12/31/19, he/she isn’t forced to take age-based withdrawals from their traditional IRA accounts until the year in which they turn 72. At that time, forced distributions commence and are fully taxable as ordinary income, unless given to charity according to the rules that govern Qualified Charitable Distributions (QCDs). So as not to end up with a large, unexpected (and often unpleasant) tax bill at year-end, many choose to have taxes withheld from each of their traditional IRA distributions as they’re made. Most often, a fixed percentage is withheld from the gross amount of each distribution, while, at other times, a given distribution request is grossed up for taxes. This allows the individual to receive the exact amount of the distribution they requested, net of taxes. While the withholding of any tax from traditional IRA distributions is not specifically required throughout the year, doing so can be an effective way to avoid the underpayment of taxes, as well as any penalties and interest that might apply.

In the U.S., we have a pay-as-you-go system where one pays taxes on income in the year it is earned or otherwise received. If you owe more than $1,000 in tax at the end of any given tax year, you must generally have withheld or paid at least 90% of your current year’s tax liability or 100% of your prior-year’s tax liability, whichever is smaller, to avoid incurring a penalty. The penalty for the underpayment of taxes in 2020 was 3.398% of the underpayment, which was reduced slightly if you satisfied your obligation in full by April 15th of 2021.

In addition to payroll withholding and withholdings from traditional IRA distributions, many people set out to avoid the underpayment of taxes by making estimated quarterly income tax payments. These payments are generally made on April 15th, June 15th, September 15th and January 15th of the following year, in amounts equivalent to one-fourth of the prior year’s actual tax liability. The trouble with this methodology is that in a year when excessive capital gains are realized, it results in unusually large estimated quarterly tax payments in the following year, when realized gains that year might be far less, thus resulting in an overpayment of tax. Conversely, in a year when very few capital gains are realized, the following year’s estimated quarterly tax payments might be unusually low, when actual realized gains that year might be unusually high; this would result in an underpayment of tax. Whatever the result, a reconciliation takes place every year when we file our tax returns. If we’ve withheld too little, we rectify the situation by making a lump sum payment or otherwise arranging for the payment of any monies due in a series of installments. If we’ve withheld too much, we receive a refund or otherwise choose to apply the overpayment to the following year’s tax liability.

At the end of the day, individual income taxes represent approximately 50% of the revenue our Government collects, with an additional 36% of revenue coming from payroll deductions for social insurance programs like Social Security and Medicare. If you know of any other individual candidates or any other special delivery mechanisms to participate in or otherwise enhance this vital source of funding, please bring them forward. With a 2021 projected budget deficit of $2.3 trillion dollars according to the Congressional Budget Office (CBO), we’re going to need all the help we can get.

To see this column in the RBJ, click here.

Tax information presented is not to be considered as tax advice and cannot be used for the purpose of avoiding tax penalties. Canandaigua National Bank & Trust does not provide tax, legal, or accounting advice. Please consult your personal tax advisor, attorney, or accountant for advice on these matters.

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