The annual season of giving—to Uncle Sam, at
least—is upon us. It's not such a bad thing for the
majority of taxpayers. After paying through automatic withholding
all year long, we're rewarded with a refund once we send in the
paperwork.
But that's not necessarily the case for people with a
substantial amount of income from sources other than wages subject
to withholding. Capital gains fall into that "other"
category, as do self-employment income, interest, dividends, rental
income and retirement distributions.
If you received a windfall from any of those sources last year,
you'll have to settle up with the IRS now. And if you
haven't paid a dime on that income until the filing deadline,
there's a chance you'll face a penalty and interest,
too.
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You can avoid the slaps on the wrist if you had at least as much
income tax withheld this year as last (unless you make more than
$150,000, in which case you have to hold back at least 110 percent
of the prior year's withholding). Alternatively, you're
protected from IRS penalties if you had at least 90 percent of what
you owe for the current year withheld.
Even so, there's still the tax itself. It may be too late to
do much about the 2003 tax bill, but there's still plenty of
time to plan for 2004. Plan ahead if you think you'll have
significant income from any of the nonstandard sources this
year.
The simplest and most conservative way to plan ahead is to
calculate the likely tax on your earnings and write out a check
immediately. The downside is, you lose any chance to earn interest
on that money during the year.
A middle-ground option is to calculate the tax and send in
quarterly estimated payments. That way, you avoid the penalties but
don't have to pay all the money upfront.
You could also, of course, calculate the likely tax and then set
that amount aside in a money market account or interest-bearing
checking account until you actually have to pay. That way, you keep
making money on your money until the moment you're obligated to
part with it.
If you're disciplined enough to save the tax money rather
than spend it, and if you fall into one of the penalty safe
harbors, this is the road to take. If you're not sure on either
count, make the quarterly payments.
Scott Bernard Nelson is a freelance writer in Portland,
Oregon, and an editor at The Oregonian.
Originally published in the April 2004 issue of Entrepreneur Magazine