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I made a decent amount in short-term capital gains in 2020. As I was filing my taxes this year, Turbotax informed me that I needed to pay a penalty for underpayment of estimated tax. I don't totally understand this.

Is the reason for this that I obtained capital gains during the year, but did not withhold/pay any money on them until just now? Of course my employer withheld the appropriate amount from my salary, but is this penalty saying I should also have been making additional payments on the capital gains throughout 2020?

  1. How and where do I do this?
  2. How do I determine the amount?
  3. Isn't this a bit speculative? What if I make $25k in January of 2020, make a payment for those capital gains, and then proceed to lose $30k for the rest of the year? Is it just money I need to basically give up, and then maybe get back later if I overpaid?
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It doesn't matter what kind of income you owe taxes for (capital gains, wages, or whatever), the rules for the underpayment penalty are the same. There are two safe harbor levels: 90% of this year's tax liability, or 100% (110% for those with AGI above $150k) of last year's tax liability.

If your withholding (from paycheck) by itself reaches either of the safe harbors by the end of the year, you do not need to have paid any estimated taxes and you won't have an underpayment penalty. You might still owe some taxes, but those would only need to be paid by the tax filing deadline (usually April 15 of the following year). So you have the option of simply increasing your withholding a sufficient amount and not need to pay estimated taxes.

If your withholding is insufficient to reach the safe harbor level, then you need to pay estimated taxes to reach the safe harbor level. If you need to pay estimated taxes, you need to pay a sufficient amount each quarter by that quarter's deadline. The due date for first, second, third, and fourth quarter estimated taxes are usually April 15, June 15, September 15, and January 15 of the following year, respectively.

There are two ways to determine whether you've paid enough estimated taxes each quarter. One is you pay 1/4 each quarter. So if you take the safe harbor level, subtract the amount of withholding you had over the year, and divide by 4, that is how much you need to have paid each quarter. The other is the Annualized Income method, which calculates how much you need to pay each quarter based on the amount of income you have up to each quarter. The Annualized Income method is more beneficial in cases when you get more income in later quarters. You can see all of these calculations on Form 2210, which calculates the underpayment penalty. So any way you do it that can get to 0 underpayment penalty, as calculated by Form 2210, means you have paid enough.

If your income was lower or about the same last year, the simplest thing to do would be to reach 100% (or 110%) of last year's tax liability, either with withholding alone, or withholding plus estimated taxes, paid 1/4 in each quarter.

If you want to reach 90% of this year's tax liability, you can do that by adjusting your withholding as you go. If you wish to reach 90% of this year's tax liability by withholding plus estimated taxes, then it's a little tricky. You don't know your tax liability this year, so doing 1/4 of your estimate of your tax liability might be risky. So if you want to pay estimated taxes based on this year's tax liability, to be safe, you should do it based on the Annualized Income method.

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  • Also, they don't expect you to make the estimated payment until your gain actually occurs. So if you have gains in December that add $20,000 to your tax bill, they do not expect you to magically foresee this and make $5000 estimated payments in April, July and October. – Harper - Reinstate Monica Mar 31 at 7:26
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    This is a gold-standard answer and should be used to mark duplicates of similar questions. Great, brief, explanation in the opening, and very detailed followup. – Grade 'Eh' Bacon Mar 31 at 14:21
  • @Harper-ReinstateMonica: Yes, but in that case you would have to use the Annualized Income method – user102008 Mar 31 at 16:37
  • Are there any "pay enough per quarter" rules for withholding, or are you technically allowed to backload your withholding and get away with it? I haven't found any such rules, but it feels weird for such rules to only exist for estimated tax payments. – user2357112 supports Monica Mar 31 at 19:05
  • @user2357112supportsMonica: You can backload withholding and get away with it, as long as withholding alone reaches the safe harbor level by the end of the year. – user102008 Mar 31 at 21:19
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Here's a tool from the IRS to see if you need to pay estimated taxes: https://www.irs.gov/help/ita/am-i-required-to-make-estimated-tax-payments

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