How to avoid paying estimated taxes due to unpredictable investment income?

Question

I've read that you'll owe a penalty if you don't pay enough in taxes during the year, and I'd like to avoid paying estimated taxes if possible since I have significant and hard-to-predict investment income. According to the IRS:

Generally, most taxpayers will avoid this penalty if they owe less than $1,000 in tax after subtracting their withholdings and credits, or if they paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller.

Assuming you owe more than $1000 and you receive investment income which is tough to estimate in advance, and will certainly result in paying less than 90% of the taxed eventually owed, how do you meet the last criteria, ie paying 100% of the tax from the prior year?

Specifically, where on one's prior year return do you find this 'tax' number? Is it line 63 on the Form 1040? Once you know this number, what is the proper way to handle it? Would doing the following be correct? :

• Get 2019 tax paid (withheld from paycheck) estimate as follows: find the line that says federal tax deduction on paycheck, multiply this by 26 (paycheck is once every 2 weeks)
• Get 2018 tax (Line 63??)
• Calculate "Gap" as 2018 tax minus 2019 tax paid estimate
• Calculate "Gap" divided by remaining paychecks in calendar year, and enter this value on line 6 of an updated W-4

For example, if I determined my 2018 tax was $20K, used my last paycheck from my employer to compute my eventual total 2019 federal witholding as $18K, calculated the difference as $2K, and assuming there were 10 pay periods left in the year, determined I needed $2K/10 = $200 in federal taxes taken out of each of my remaining paychecks by updating my W-4 to include $200 on line 6 (or better yet 110% of $200 or $220 to give myself a bit of safety cushion)

Does this sound correct? Basically I'm trying to make it so that my 2019 federal tax deductions from my paycheck meet or exceed my 2018 tax (because I don't want to have to estimate my investment income and make quarterly payments to the IRS)

Answer 1

Yes, that sounds correct. If you change your withholding any time in the year so that the total withholding for the year meets 100% of last year's tax (or 110% of last year if your AGI last year was above $150k) or 90% of this year's tax (it's actually 85% this year), you don't need to pay estimated taxes, and you won't have an under-withholding penalty for federal taxes. This is true no matter which part of the year the tax was withheld in (this is unlike for estimated taxes, where you must pay enough in each quarter, or you will have a penalty even if the total amount in the year is enough).

You can look at Form 2210 and its instructions to see how the penalty is calculated. The amount from last year's taxes that you need to have withheld 100% (or 110%) of is calculated in the instructions for line 8. Specifically, if you filed Form 1040 in 2017, the amount is basically the sum of lines 56, 57, 59, 60a, 60b, and 62 with some exceptions.

(Note that the conditions for avoiding the under-withholding penalty for your state taxes might be different. Withholding 100% or 110% of last year's taxes may not be enough to avoid the penalty in some states under certain conditions.)

Answer 2

IRS Pub 505 for 2019 details how to use your 2018 taxes to make the 2019 safe harbor:

Remember that the tax forms changed a lot this year. Many line numebrs are differnt.

Total tax for 2018. For 2018, your total tax on Form 1040 is the amount on line 15 reduced by the following.

1. Unreported social security and Medicare tax or RRTA tax from Forms 4137 or 8919 on Schedule 4 (Form 1040), line 58.
2. Any tax included on Schedule 4 (Form 1040), line 59, for excess contributions to an IRA, Archer MSA, Coverdell education savings account, health savings account, and ABLE account; or any tax on excess accumulations in qualified retirement plans.

3. The following write-ins on Schedule 4 (Form 1040), line 62.

   a. Uncollected social security and Medicare tax or RRTA tax on tips or group-term life insurance.
   b. Tax on excess golden parachute payments.
   c. Excise tax on insider stock compensation from an expatriated corporation.
   d. Look-back interest due under section 167(g).
   e. Look-back interest due under section 460(b).
   f. Recapture of federal mortgage subsidy.

4. Any shared responsibility payment on Schedule 4 (Form 1040), line 61.

5. Any refundable credit amounts on Form 1040, line 17a, b, or c, and Schedule 5 (Form 1040), lines 70 and 73, and credit from Form 8885 included on line 74.

Once you know what your 2018 taxes are:

• Determine if you need to meet the 100% or the 110 percent goal.
• Assuming the numbers that you quoted in the question of 20K in 2018 taxes, that would be 100% ( $20,000) or 110% ( $22,000K).
• determine how much your W-2 jobs will have in withholding based on your current paychecks and withholding. You estimated that you would reach $18,000.
• assuming the 110% goal that would mean you are $4,000 short.
• so spread that 4,000 over the remaining checks by putting a number in line 6 of the federal W-4.
• based on your example that would require an additional $4,000 over the last 10 paychecks.