Brace Yourself

Want to avoid getting hit by the IRS? Plan ahead.
Magazine Contributor
3 min read

This story appears in the April 2004 issue of Entrepreneur. Subscribe »

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.

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.

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