How do I get my withholding correct when a significant amount of my income doesn't arrive until late December?

Question

Almost half my taxable income last year arrived in late December, in the form of two things: 1) a large Christmas bonus (company politics mean I haven't had a real raise in a decade, but my bonus has been growing to compensate), and 2) mutual funds doing whatever it is they do to turn market movement into real income. This resulted in my tax withholding being almost $7000 too low.

How can I get the correct amount withheld? The usual method of computing your taxes throughout the year and adjusting your W-4 to compensate doesn't apply, since I don't know the size of either of these until after I get my final paycheck of the year. A lump withholding wouldn't be too effective either, since that involves predicting what the markets will do.

Answer 1

The most obvious answer is to pay an estimated tax (using form 1040-ES) for the year-end lump sum income items you have. The last 1040-ES payment date is January 15th of the year after, precisely to account for situation like yours. By that time you already know exactly how much your income was and how much was withheld and can calculate the missing portion to submit with the 1040-ES.

Alternatively, you can add "other income" to your W4 with your estimates of these items, and deal with over/under withholding at tax time.

Another option is to adjust your supplemental withholding rates (those are the withholding rates for the bonus payment). However, not all employers allow that.

Answer 2

You have several options:

• if late in the year you know that you will be writing a check to the IRS and the state, you could change the W-4 withholding to have extra funds withheld from the last few paychecks. That can be difficult to do if you mess the deadline to change the last paycheck or two. Also remember to change it back in January.

• If you want to wait until the year is done, you can file an estimated tax form due in January. You still will be writing a lump sum check to the IRS, but it does avoid penalties.

• If you have a reasonable expectation of being in this situation every year, then have additional funds be withheld over the entire year to make the safe harbor level. In a nutshell you make sure that you have enough withheld to meet the previous years tax obligation.

From IRS Pub 505

Who Must Pay Estimated Tax

If you owed additional tax for 2021, you may have to pay estimated tax for 2022.

You can use the following general rule as a guide during the year to see if you will have enough withholding, or should increase your withholding or make estimated tax payments. General Rule

In most cases, you must pay estimated tax for 2022 if both of the following apply.

1. You expect to owe at least $1,000 in tax for 2022 after subtracting your withholding and tax credits.

2. You expect your withholding and tax credits to be less than the smaller of:

   a. 90% of the tax to be shown on your 2022 tax return, or

   b. 100% of the tax shown on your 2021 tax return. Your 2021 tax return must cover all 12 months.

Note. The percentages in (2a) or (2b) just listed may be different if you are a farmer, fisherman, or higher income taxpayer. See Special Rules, later.

But there is an additional provision for people with high incomes:

Higher Income Taxpayers

If your AGI for 2021 was more than $150,000 ($75,000 if your filing status for 2022 is married filing a separate return), substitute 110% for 100% in (2b) under General Rule, earlier.

For 2021, AGI is the amount shown on Form 1040 or 1040-SR, line 11.

If you make sure that you use the W-4 to make the previous years tax (or 110 % of the previous years tax) you can avoid penalties for a large check. However you do have a good chance of getting a large refund if the year turns out to be a low income year. If it turns out to be an excellent year bonus wise, even if you write a check, the IRS won't be looking for a penalty.

Answer 3

If this is the first year this happened, your withholding from your regular pay and bonus probably exceed 100% (and even 110%) of last year's tax, so you probably has no underpayment penalty this year.

If it happens in a future year that you got a lot of extra income in December, you can pay 4th quarter estimated taxes by January 15th to reach 90% of your tax for the year, and that should avoid the underpayment penalty. Normally, you have to pay 1/4 of the underwithheld amount in estimated taxes by each quarter's estimated tax deadline, so paying it in the 4th quarter does not avoid the underwithholding penalty if you underpaid in the first 3 quarters. However, you can choose to calculate the amount of estimated taxes required each quarter using the Annualized Income method (Form 2210 Schedule AI), which considers the income up to each quarter to determine the estimated taxes that should be paid by that quarter. This is useful for situations where the income increased in later quarters. Assuming your withholding was sufficient for the income rate that you had in the first 3 quarters, you wouldn't have an underpayment penalty for those quarters. (Though annualizing income has the disadvantage that you basically have to go to the effort of dividing your income into quarters.)

Answer 4

I've long since given up on getting this right. I just go with the safe harbor of 100% of last year's tax payment. We have no W-2 income, when I do the taxes I take the total tax bill, divide by 4 and schedule 1040-ES payments of that amount and don't worry about it until next year. Interest is low, it's simply not worth the effort to optimize it. It's also turned out more accurate than trying to figure it out.